Buffett's rules for your DIY fund - Eureka Report article
Buffett's rules for your DIY fund
SCOTT FRANCIS – 16 SEPTEMBER 2013
Summary: Investment guru Warren Buffett has made tens of billions of dollars by following a disciplined approach to investing. Nearly 40 years ago he wrote a letter to the Washington Post detailing his key strategies for managing pension assets, and they’re still just as relevant today as they were back then.
Key take-out: More than anything else, Buffett warns people to be prepared over the long term to deal with inflation.
The superannuation system in Australia forces people to take on a tough role – being the manager of their pension assets. Roughly one-third of the assets of the superannuation system are now controlled by DIY funds.
Indeed almost 1 million people are dependent on the successful management of self-managed funds, and that number is rising every year.
But with power comes responsibility: Running a DIY fund can be demanding, and in times of financial stress (such as the years surrounding the GFC) the pressure can be quite intense.
There are multiple decisions that come with managing a pension account into and during retirement, but perhaps the three most important issues are:
As I said, it’s not easy, but there is help at hand – and it comes from none other than Warren Buffett, the world’s greatest living investor. To be precise, it comes from a memo sent nearly four decades ago from Buffett to the former head of the Washington Post Company, in October 1975.
The Washington Post Company was the first major stock investment for Buffett and his Berkshire Hathaway investment company – in 1973 he put $10 million into the company, and by 1977 his investment had tripled.
As the investment matured Buffett became more engaged with the diversified newspaper company and he became a key ally of the legendary publisher, Katharine Graham.
Buffett may have been making money hand over fist in what was then the glory days of The Washington Post – the newspaper had virtually brought the Nixon administration to its knees through the efforts of reporters Bob Woodward and Carl Bernstein. Nonetheless, Buffett did not think the pension scheme at the company was being run properly.
The letter is addressed Katharine Graham, whose son Don Graham was recently key to the deal where the newspaper assets of the still-listed company were sold to Amazon’s Jeff Bezos.
Remarkably, after the recent Bezos deal, it has become clear that although The Washington Post has many problems – the pension fund is not one of them. In fact The Washington Post pension fund has about $1 billion more than it needs to pay its obligations, according to the US Fortune magazine.
Buffett’s letter to Graham and the board of The Washington Post stands as an essential document for anyone seeking principles for running a pension fund.
To view Warren Buffett’s full 1975 memo to Katharine Graham, click here.
In essence then the letter puts forward five outstanding principles for commencing and managing any pension fund operations … DIY funds could benefit greatly from these instructions.
1. Look Before You Leap
At the very beginning of the letter, Buffett warns Graham on the risks of making set promises to anybody. The particular problem at hand was the promises being made to journalists and printers at the Washington Post Company.
In terms of DIY funds this could be translated as the risks of promising yourself, or those close to you, that you can actually run a successful fund.
As Buffett suggests: “know what you are getting into before signing up.”
2. The Hamburger Factor
Buffett talks about inflation’s impact on pension obligations by talking about a “1,000 hamburger a month obligation”. Because the hamburger will increase in price over time, it is difficult to know how much capital is needed to fund this obligation, or your retirement, as goods and services increase over time.
As we plan our pension, it is crucial to think about how goods and services will increase over the timeframe of our retirement. This will lead us to think about putting aside additional assets prior to retirement, and being conservative in the rate we withdraw on out assets to fund retirement.
Inflation may be low at the current time, but when you are dealing with pension funds you are dealing with very long periods of time – bear this in mind, inflation is widely expected to rise in the years ahead. I am often surprised by how many people plan to withdraw 7% a year from their retirement assets – where 4% to 5% is far more realistic.
3. Buy Businesses, Not Stocks
Buffett then moves to consider the different approaches to managing the sharemarket investments of a pension account.
The first option is the use of “large conventional money managers” – today’s equivalent of fund managers in the Australian environment. He then makes a number of very sophisticated arguments as to why this approach must lead to returns “slightly poorer than average”. This includes the observation that collectively, the large fund managers make up a large portion of the market and so, after costs, are unlikely to perform the average return. He also makes the points that as these funds trade they incur costs, and these costs move to further reduce returns. He also comments that “I am virtually certain that above average performance cannot be maintained with large sums of managed money”.
The second option he suggests – which was new at the time – was the use of an index style investment to capture slightly lower (because of fees) than average market return.
The third option is to try and identify an investment manager managing small amounts of money with a good record – and then “hope that no one else finds him”.
The last strategy he talks about is to “treat portfolio management decisions much like business acquisition decisions”. This is, of course, the preferred Buffett option. He says that he leans toward this approach, although “not at anything like a 45 degree angle”. In other words, don’t think of stocks as stocks, rather think of them as buying a slice of a business.
4. Fixed Income Investments Are Not Enough
After the sharemarket fall and volatility during the global financial crisis, a fixed interest strategy has an appeal for many investors. However, as Buffett points out in his letter, while the comfort level with this strategy might be “high”, inflation is the problem.
As Buffett warns early in his missive to Graham in the context of superannuation, “errors compound”. In other words, if you’re asset allocation is wrong in the early years of a fund you might not get that essential early growth in capital you are looking to achieve in order to finance a more conservative later-in life investment asset allocation.
5. Nobody Beats The Market All The Time
In what would later become a regular refrain from the ‘Sage Of Omaha’, Buffett warns Graham that the plethora of professional fund managers, even then promising to “beat the market”, simply could not deliver … mathematically!
As Buffett says: “A little thought or course would convince anyone that the composite area of professionally managed money can’t perform above average.”
Having made the point theoretically, Buffett later puts it in more colloquial terms: He suggests: “It’s analogous to the fellow sitting down with his friends at the poker table and announcing ‘well fellows, if we all play carefully tonight , we all should be able to win a little’.”
And just to douse enthusiasm for fund managers even further, Buffett takes another dig at them later in the memo with the remark: “I am virtually certain that above-average performance cannot be maintained with large sums of managed money.”
6. Get Tough … Handle Volatility
Buffett also comments on the volatility of sharemarkets, acknowledging that they “may bounce widely and irrationally”. However, he counters this by reminding us that the time frame for a pension investment is long – a retirement could be 30 years or more. Therefore, returns should be measured over longer periods of time, as the “time span against which pension fund results should be measured” is a longer one.
This is important for us as we manage our pension assets – it is easy to get distracted by short-term returns, however it will be 10, 15 and even 20-year returns that will be crucial to the success of our retirement strategies.
The most remarkable thing about reading a Warren Buffett letter from almost 40 years ago is how relevant his advice remains. As the pension manager of our own funds, his advice on pensions is worth keeping in mind – whether it be about market timing, investment approaches, the importance of thinking about inflation or the balance between sharemarket or fixed interest investments, it will serve any investor well.
Scott Francis is a personal finance commentator, and previously worked as an independent financial advisor.