Highlights from the Berkshire Hathaway shareholder’s meeting 2012

I finally got around to visiting Omaha to hear superinvestor & ‘world’s 3rd richest man’ Warren Buffett and his business partner Charlie Munger hold forth at the annual Berkshire Hathaway shareholder’s meeting on May 5th, 2012.  For those of you who aren’t Buffett fanatics (you should be; start with this, then this, and then read these), Berkshire Hathaway is a conglomerate of insurance companies & other businesses that Warren Buffett has presided over for some 35+ years, and has returned ludicrous results to its investors (which are NOT likely to be repeated, mind you!)

Every year, thousands (about 35,000 this year) flock to Omaha to hear about the condition of their beloved company, to shop at Berkshire subsidiaries like See’s candies and GEICO, and to catch the pearls of wit & wisdom that drop from the mouths of Buffett and Munger.

Watching the dynamic of Buffett & Munger as they each added their ‘2 cents’ to the varied discussions was highly entertaining, and often elucidating.  Buffett, long-spoken, friendly, upbeat, and literary, was contrasted and complimented by Munger’s laconic, pessimistic (he might say realistic), and sharp-tongued (and often hilarious) responses.

My notes

Lest such pearls escape me, I furiously scibbled notes during the 5 hour question & answer session during which Buffett and Munger deftly responded to questions from investors, media, and analysts on a host of topics ranging from investing to politics to ethics.

Here’s the ‘best of’ what I was able to catch and jot down.  Please note that while I often tried to capture exact quotes, a good deal of even the quoted material may not be ‘word perfect.’

The newspaper business

One shareholder asked Buffett about the recent purchase of a (print) newspaper, the Omaha-World Herald.  Given the declining economics of print media, the shareholder was (quite rightly) concerned about the future of newspapers.  Buffett responsed that he “believes in newspapers where there’s a sense of community.”  And explained that papers must have “primacy” (primary importance) in an area that the people who read it are interested in.

He described how traditional domains of newspapers (stock prices, classified ads, real estate listings) no longer have ‘primacy’ for their readership, who have largely moved on to the internet as the primary source for such info.  However, Buffett believes that community papers with local issues (like obituaries) can still thrive in the digital age, so long as those papers can remain as the most important source of that community-centric information for the paper’s readers.

Management of Berkshire’s businesses

Buffett often talks about the quality of management hired to run Berkshire’s subsidiaries.  Buffett claims to do nothing more than 1) make capital allocation decisions with the cash that Berkshire’s subsidiaries create and 2) create an environment (including compensation arrangements) to retain and attract top-quality managers.

Commenting on how independently competent Berkshire’s managers must be when it comes to running their operations, Buffett commented that “if we thought the success of our investment [in a subsidiary] depended on our advice [to management], we wouldn’t make the investment.”  In describing the work environment for managers that he tries to create, Buffett noted that he “can’t create passion in someone, but he can take it away [through a bad management structure.]”

One aspect of creating a good management structure is appropriate compensation. Berkshire has hired two former hedge fund managers to invest funds for Berkshire’s own portfolio.  These managers will receive 10% of any 3-year rolling gains above the S&P 500, incentivizing them to beat the stock market average, but also making sure they have to do it on a long-term basis.  Additionally, 80% of each individual’s bonus will come from his own efforts, but 20% will come from that of the other guy’s performance, as an incentive for them to work together and share investment ideas.

Munger added that “90% of those in the investment business would starve to death on that [compensation] formula.”  (Although I’ll add that each of those two Berkshire investment managers also receive a ‘base’ salary of $1 million per year, so ‘starvation’ probably shouldn’t be taken literally.  Interestingly, any employees or other expenses that these managers create must come out of that $1 million, which I thought was a nice way to sync incentives between the managers and Berkshire.)

Buffett also talked about how Berkshire didn’t use ‘compensation consultants’, who, in Buffett’s opinion, generally just tell CEOs and boards what they want to hear anyway.  In straight-faced monotone, Munger opined that “prostitution would be a step up” from compensation consultant, to which Buffett quickly added “Charlie’s in charge of diplomacy at Berkshire too.”

Creating shareholder value

When asked why Berkshire wasn’t paying a dividend, Buffett answered that “we feel we can create more than $1 of present value per $1 retained.”  Munger said he thought that “Warren’s learned new things each decade, resulting in much better results” at Berkshire than expected at the outset of their venture.  Munger, 88 years old & 7 years Buffetts senior, then added wryly, “but he’s getting old; I’m worried about him.”

Competitive advantages

“We sort of buy[s] barriers to entry; we don’t build them”, said Munger.  Buffett gave the example of the brand strength of Coca Cola, and how virtually impossible it would be to take away their market power.  Richard Branson, found of Virgin Airlines, and other Virgin companies, started ‘Virgin Cola’, which failed.  Buffett made the remark that “people say a brand is a promise.  I’m not sure what [Branson] was promising” with his cola brand.


Buffett noted that “if you caress an ounce of gold for 100 years, you’ll still have one ounce of gold”, and then compared that to the huge growth in what you’d have from growing businesses that pay out and reinvest cash, or to farmland that produces valuable crops every year.

This fundamental principle, that gold doesn’t actually ‘produce’ anything, is behind the fact that only periodic and unanticipated demand for it can drive the price up.  This also explains why, despite the last several years of the run up in gold prices, gold’s real return (after inflation) has only been slightly positive.

If one compares that to the massive growth of stocks, and even the modest growth of bonds, over long periods of time (not to mention the price swings of precious metals), it’s clear that gold is a very poor investment in itself.


When asked about the prevalence of the corporate political fundraising vehicles called ‘Super PACs’, Buffett stated that, even if donations to such a vehicle would increase Berkshire’s profits, he was morally opposed to it, and wouldn’t do it: “The whole idea of Super PACs is wrong, and relatively huge money [going to politicians] from a few people is wrong.”  While he acknowledged that others might defend their contributions to Super PACs by pointing out that their corporate competitors are doing it, Buffett asserted that “you have to take a stand somewhere.”

Munger added that he might consider giving to a Super PAC if he actually thought he could stop something really bad, and gave legalized gambling as an example of something that “does us no good” as a society.  And that “making the securities market more like gambling” was also going on, and also bad.


Buffett said that the tax code is important in sharing wealth, and that it may be the case that the natural “trend in democracy that pushes toward plutocracy.”  Therefore, we should use the tax code as a “countervailing balance” against this anti-democratic, and yet perhaps expected, outcome of our market-based economy and its liberal principles (I mean ‘liberal’ in the free sense, not in the left-wing sense.)

On corporate taxes, actual taxes paid by corporations were 13% of revenues in 2011, versus the marginal rate of 35%.  Despite the play that US corporate tax rates get in the press, Buffett stated that neither corporate tax rates nor balance sheets nor liquidity were holding back the US economy.  Buffett called medical costs the “tape worm” of American business, and noted that they composed about 17% of GDP, versus a mere 2% for corporate taxes.  Munger also added that he thought a Value Added Tax should probably come into play in the US.

Munger thinks that “Paul Krugman is a genius” but that he maybe too optimistic about “Keynesian economic tricks.”  He also asserted that, in the US (and presumably around the world), we’ve lost a good deal of our “fiscal virtue”.  “Everybody wants fiscal virtue, but not yet.  Like [Saint Augustine], who was willing to give up sex, but not quite yet.”

Energy policy

Munger said he supports subsidies for wind and electric cars “to wean us off oil and gas.”  It “would’ve been better to use up other [countries’] oil” and to have kept our own in the US as a “strategic reserve” over the past decades, said Buffett.  Munger agreed with this, saying “I’m a puritan and believe in suffering now and making the future better.  That’s how I believe grown people should behave.”

I thought this was a great quote, and that it bears on several issues facing the US, such as the ballooning debt that’s being placed on the backs of young people in America.  I personally feel that too much is being done in the US to avoid short-term sacrifice at the expense of future prosperity.

Recent market crises (Europe & also 2007-2008 in the US)

“Alan Greenspan overdosed on Ayn Rand as a youth…  Greenspan was really wrong [on his actions that helped precipitate the 2007-2008 US recession.]  He’d think an ax murder was okay if it happened in a free market.”  Harsh, and humorous, words from Charlie Munger on the former US Federal Reserve chairman.

Due presumably to the low interest-rate environment*, and the fact that yields aren’t significantly higher (in Buffett’s opinion) for long-term vs short-term bonds, Buffett noted that he’d “avoid medium and long-term [US] government bonds.”

* Bond prices move inversely with interest rates, so if rates go up, the prices of existing bonds go down (and vice versa.)  The longer-term a bond is, the more its price is affected by interest-rate changes, hence Buffett’s shyness about longer-term bonds.


Both Buffett and Munger dismissed the investment risk ‘measurements’ used today by many large money managers like sigma (standard deviation, generally of a normal distribution), beta, and value at risk (VaR).  According to Munger, ‘value at risk and such are … some of the dumbest ideas ever’.  They criticized heavily the ‘precise’ (but not necessarily accurate or even useful) mathematical models used by finance and math PhDs to try to predict various events with many decimal places of certainty (think of Long-term Capital Management to understand where Buffett & Munger are coming from.)

Munger repeated a story of investor Sandy Gottesman firing a young man who was a major ‘producer’ (i.e.: money maker) at Gottesman’s investment firm.  The producer objected to being fired on the grounds that, despite the alleged riskiness of his investments, he had made a lot of money for Gottesman’s firm.  Gottesman replied “yes, but I’m a rich old man and you make me nervous!”

Buffett equated much of the failure of math-heavy risk management with a poor grasp of history, and of the many investing blow ups of the past.  He said that he keeps copies of newspaper articles from market crashes as a reminder of worst-case scenarios, including one about a man who killed himself in a boiling vat of beer during the May 1901 crash!

Buffett noted in this year’s annual shareholder letter that risk is not the volatility of an asset, but rather the chances of a decline (or unsatisfactory gain, I would say) in purchasing power as the result of an investment.  As a financial advisor that helps clients reach specific goals that rely on the purchasing power of their investments, I agree that this is the only meaningful way to think about financial risk.

He also noted that you shouldn’t “risk what you have & need to get what you don’t have & don’t need.”  Wise words, and applicable to more than just investing.

Avoiding mistakes

“We’re always thinking about worst case scenarios”, said Buffett.  Munger adding “studying other people’s mistakes” was key as well, and that both Buffett & himself were keen students of “folly”.  “People with 180 IQs didn’t have an understanding of human behavior”, noted Buffett when describing the causes of recent blow ups around the turn of the 21st century.

Business schools and how to think about investing

Buffett criticized business schools for teaching ‘fads’, and also suggested he didn’t put much stock (no pun intended) in ‘finance theory’, like that of efficient markets or modern portfolio theory.  Charlie Munger commented that while there was some rationale for these topics, business school teachings on investing were ‘a considerable sin’.  (Despite this, I’d argue from other things each have said that Buffett & Munger do acknowledge some of the more general points of modern finance theory like market efficient MOST of the time.  They take issue with the ‘semi-strong form’ of market efficiency, arguing that publicly available information can be used to make profitable (after controlling for volatility) investments.  I think they also take issue with the use of finance theory as a tool with high predictive value in, say, valuing businesses and stocks.)

Buffett stated that he would have two courses taught to teach students about investing: one on how to value businesses (which I would assume would be done using accounting statements & other means to approximate future cash flows, and then discount those cash flows back to the present.)  The other class would be how to think about markets (e.g.: read Chapter 8 of Benjamin Graham’s ‘The Intelligent Investor‘.)  By thinking about markets, Buffett means that you should treat market prices as random fluctuations that are there to serve you (by sometimes offering prices that are lower than the value of what you are buying), not to guide you (i.e.: causing you to panic and sell when prices fall, or become gleeful when prices rise.)

The result of this business valuation would be to ‘understand’ a business.  To wit: “understanding a business means having a good idea around 1) its competitive position and 2) its earnings power 5 years from now”, said Buffett.

Munger added that if you receive any offer to buy an investment product with a large commission, “don’t read it.”  Instead, he suggested “looking at things other smart people are buying.”  That said, you must make sure you use others’ ideas only as starting points, and do all of your homework to ensure you understand the business, and can value it against its current price, factoring in some ‘margin of safety‘ in case your estimates are wrong.


If you just can’t get enough Buffett/Munger action, or else want to compare the validity of my ‘journalism’ to that of other sources, here’s some alternative coverage of the 2012 Berkshire meeting, along with some other related links:

NY Times considers Buffett’s politics: http://dealbook.nytimes.com/2012/05/07/reflecting-on-buffett-business-and-politics/

Highlights from the meeting from Reuters: http://www.reuters.com/article/2012/05/05/berkshire-meeting-highlights-idUSL1E8G52T920120505

Munger-mania! (Highlights from an awesome 2-hour U of Michigan speech, also available on YouTube) ‘The Motley Fool’: http://www.fool.com/investing/general/2012/05/04/charlie-munger-on-communism-botox-and-goldbug-jerk.aspx

Buffett talks to MBA students at Florida U in 1998 (great talk in 10 parts): http://www.youtube.com/watch?v=ogAxzPaU5H4&feature=relmfu

Why picking stocks is a ‘Loser’s Game’

I just read Charles Ellis’s classic 1972 paper “The Loser’s Game“.  In plain English (and only 7 pages), Ellis deftly describes why professional investors fail, and will continue to fail, to beat passive indexes (which are my favorite investment recommendations.)

It’s a good read if you’re interesting in investing.  (If you ignore my and Ellis’s advice, here’s a brief primer on how to go about picking individual stocks.  Proceed at your own risk.)

Vanguard lowers fees again – switch to Admiral shares to save!

Index fund-pioneering mutual fund company Vanguard has a history of lowering fees.  Vanguard lowered the minimum amount investors need in a single fund from $100,000 to $10,000 to qualify for Vanguard’s lower-fee “Admiral” share class.

If you have Vanguard index funds with $10,000 more in them, convert them to Admiral shares and save!  (Or switch to Vanguard if you don’t currently use them and are looking for better investments at lower cost; they’re the best!)

I just converted my applicable Vanguard funds today to Admiral shares (and did the same thing for my clients.)  Go to your Vanguard account and click the ‘Convert to Admiral shares’ in your account view to see if you have any eligible funds to convert.

Here’s the news story that gives more details on this:


10 Investment Mistakes to Avoid (from NY Times article)

Okay, after a long posting hiatus due to a combination of laziness, summer fun and European vacation, I’m back and ready to post!  Here’s a good article I found on 10 common and critical investment mistakes.

Read it (it’ll only take a few minutes) and apply to your own situation.

(Yes, that was a lame post after a ~3 month dry spell, but don’t worry,  some really good original works are coming soon, I promise!)

Another reason to love Vanguard: lower brokerage fees

You may already know that I’m a HUGE Vanguard fan.  Their rock-bottom index fund fees, selection, online account features, and investment philosophy just can’t be beat.  Well, there’s another reason to celebrate them: as of May 4th 2010, Vanguard has significantly reduced its brokerage trading fees.  (See THIS for more details.)

For stocks, commissions are $7 if you have $50,000 – $500,000 in assets (and a ludicrously low $2 per trade if you have more than $500K.)  Even if you have less than $50,000, you still get 25 trades per year at $7, then $20 per trade after that.  For many buy-and-hold investors still a long ways from retirement who hold only a few individual stocks (like me), 25 trades per year could be fine.

AND here’s the kicker: Vanguard’s ETFs can all be traded FREE!  This means you can buy any of their indexes as ETFs instead of funds (garnering yourself even lower annual expense ratios versus buying Vanguard’s funds.)  You can have 25 trades per ETF per year before Vanguard imposes a 60 day waiting period to prevent frequent trading.  This means that you could even dollar-cost-average into these funds twice-monthly.  (That said, if you do frequent dollar-cost-averaging, just using Vanguard’s standard mutual fund services may be better and easier.)

When things you love come together

I love my wife, and I love personal finance.  If my wife suddenly developed an all-consuming passion for, say, investing…, my god.  To me, that’s what Vanguard offering superior online brokerage service is like: when two things that you love come together (Vanguard + inexpensive online brokerage), it’s just beautiful.  It will likely be only a matter of time before I get around to transferring my Scottrade assets over to Vanguard.

What to look for in a broker

If you’re looking for an online broker to open (or transfer) an account to, consider Vanguard.  Compare its features and prices with other online brokers to make the best decision for yourself.  Especially look at trading costs (should be around $10 or less), other fees, usability of the online interface, and online features (I hate paper.)  Also, if the broker offers free dividend reinvestment (Vanguard does, as does ING Direct’s Sharebuilder; Scottrade doesn’t 🙁 ), that’s a plus.

Asset allocation rules of thumb

“Asset allocation”, or the percentage of your assets (usually just financial ones) that you put into different types of things (stocks, bonds, cash, real estate), has been shown to determine a very large portion of a person’s return.  It is also the key determinate in how much volatility your portfolio undergoes.

[UPDATE 12-21-2010: HERE is a very good, quick (5 minute or less), easy-to-use questionnaire from the good people at Vanguard that can be used to estimate your personal asset allocation.  It might be a bit conservative for my taste (too heavily weighted towards bonds instead of stocks), but it’s an excellent starting point to get a ballpark stock-to-bond split.]

While there many ways to arrive at a recommended asset allocation, it often helps to have some simple rules of thumb.  The general idea is that the older you are or the sooner you need the money, the safer your investments should be.  So while a 100% stock retirement portfolio would be great (in my opinion) for a 30 year-old with 30+ years until retirement, it would generally NOT be advisable for a middle-income retiree.

The following rules of thumb that I will discuss assume that the asset allocation is for RETIREMENT, and that the average person won’t be tapping into it until they’re between 60 and 70 years old.

120 minus your age

To simplify between all the different types of assets, people often just make the distinction between stocks and bonds.  For people that own homes and keep some petty cash in their savings or checking accounts, I think just talking about stocks and bonds works well for most people.  One such stock-to-bond ratio rule of thumb is this:  from 120, subtract your age.  The remaining number should be in stocks.  For example, if you’re 60, this rule would tell you to put 60% (= 120 – 60) of your assets into stocks, and the rest (40%) into bonds.

This rule is definitely simple, and reasonably useful.  (It used to be 100 minus your age, but that was when people didn’t live as long.)  My criticisms of it is that may tend to put too much of one’s assets into bonds, especially prior to age 60.  Historically, stocks have out-performed bonds in almost every 30 year period.  Of course, this is no guarantee that they will continue to do so, but it suggests a high probability.

In general, if you have more than 5 – 10 years to go before you need some money, it could be in the stock market.  Thus, I tend to recommend that people who still have 10-20 years to go before retirement put all of their money into stocks.  This assumes that most people will have some fixed income anyway (like social security.)  It also assumes that the person will only be using a small portion of their retirement funds per year (like 4 – 5% of the total account balance.)

Some alternatives

Since I prefer a slightly more aggressive rule of thumb than the above, I came up with the following asset allocation formula: Put 2 times the difference between your age minus 50 into bonds.  I.e.: % in bonds = 2*[Your age – 50]

So, if you’re 50 or under, you put nothing in bonds.  At 60, you’ll have 20% in bonds (= 2*[60 – 50]), and 80% in stocks.  At 70, you’ll have 40% in bonds, 60% in stocks, and so on.  This has the virtue of keeping a 100% stock portfolio until you’re 10 – 20 years out from retirement.  It also ‘catches up’ to the more conservative allocation by increasing the percentage of bonds in your portfolio by 2% per year after age 50.

Another option might be to just use a fixed allocation like 60-40 or 75-25 stocks to bonds.  You might choose to gradually switch from 100% stocks to this fixed allocation over a period of, say, 10 years, like from 50 to 60, or starting 10 – 20 years prior to your target retirement date.

Lastly, you could adjust my 2*[age – 50] formula above to take your target retirement age into account: use % of bonds = 2*[ Age – (Target retirement age – 15) ].  If you’re going to retire at 65, this works out to just 2*[Age – 50] (since 65 – 15 = 50.)  But, if you’re going to retire earlier or later, your recommended asset allocation will adjust accordingly.


Asset allocation is important.  Within each asset class, always diversify as much as you can.  Pick stock and bond index funds with low expense ratios that sample the entire market.  (Large cap and small cap, domestic and international for stocks.)

In general, I like 100% stocks as an allocation for retirement portfolios that still have 10 – 20 years until you start tapping them.  Then, gradually switch to something more conservation using one of the above rules of thumb, or something more exact like a financial advisor or William Bernstein’s “The Intelligent Asset Allocator”.

The financial media makes me laugh out loud

On the heels of my look-back at the stock market decline of 2008 – 2009, the financial troubles of Greece sent shudders through equity markets today.  While I try not to pay too much attention to the emotional swings of “Mr. Market” or his reporters, I read a quote from a trader that I couldn’t help but share:

” ‘We did not know what a stock was worth today, and that is a serious problem,’ said Joe Saluzzi of Themis Trading in New Jersey.”

Understandably, for a guy that trades stocks every day for a living, this is important.  But for this to be featured in the ‘front page’ of Yahoo! Finance suggests that it is of paramount importance for average investors and web surfers to know what their stock prices are at every instant of the day.

Well guess what?  It’s not!

If you’ve read any of my articles on investing, you know that I believe investing in stocks with a short-run focus is dumb.  Stock portfolios should be held for long-term gains and savings goals like college or retirement.  Because of this, it is pointless, time-consuming and emotionally draining to worry about the day-to-day changes in stock prices.  It can be hard to resist the temptation to check daily on your portfolio (I have the same problem), but we must resist the urge!

Super-investor Warren Buffett has been quoted as saying that a person should choose investments such that they don’t care if the stock market closes for 10 years, rendering them unable to trade or check its market price during this time.  As with many of Buffett’s simple statements, there’s a lot of wisdom in this one.

What you should do

Investors should structure their portfolios with the appropriate mix of stocks, bonds, and cash (‘asset allocation‘) and buy highly-diversified, low-fee index funds and plan to hold them up until they need the money (for at least 5 years; the longer the better.)

If you haven’t done this, give your portfolio a checkup and make sure you have an appropriate portfolio given your age and needs.  If you’ve done this, then forget about the market’s daily throes and do something more enjoyable with your free time.  Turn off CNBC and avoid the financial media’s sensationalist ‘news’ that’s designed solely to make you worry over things you shouldn’t and consume more of such stories.  Instead, sleep soundly at night, knowing that you’ve structured your investments such that they require only occasional maintenance and review.

To see if you might benefit from the help of a professional financial advisor, check out my website at greenlakepartners.com.

Intro to Investing (asset allocation, stocks, bonds and more!)

After understanding where you should put your money, you need to know WHAT to put it in.  The ‘what’ question is first one of ‘asset allocation’, which is just a fancy way of saying what kinds of things you should buy as investments.  These categories, or ‘asset classes’, are broadly defined as either financial instruments (stocks, bonds, cash) or property (real estate, gold coins, mint-condition Amazing Spider Man comics.)

Spidey notwithstanding, the only categories you really need to consider* are stocks, bonds, and cash instruments (savings accounts/CDs/money market funds.)  These 3 asset classes span the gamut of risk-reward such that you can use a combination of them to plan for ALL of your financial needs.  In general, the more ‘risk’ (how much the value of your investment goes up and down over time) in an asset class, the higher the expected return.  Therefore, one would expect stocks, the most volatile investment, to have the highest rates of return, and safer things like bonds or cash to have the lowest.

If you look at the graph below, taken from finance professor Jeremy Siegel’s excellent book Stocks for the Long Run, that’s exactly what you’ll see.  The graph shows the total real returns for stocks, bonds, treasury bills (approximating money market funds or CDs), gold and cash (= money earning 0% interest, like your checking account.)  ‘Real’ means that these returns are adjusted for inflation, a force which eats away at the spending power of your money.  This is an important adjustment because what you really care about as an investor is how much stuff you can buy with your dollars, not simply how many bills you have.

From this we can see that ultra-safe treasury bills would’ve increased your savings by 300 times, with pretty-safe bonds increasing them over 1000 times.  This sounds pretty good until you look at stocks, which increased the purchasing power of $1 by over 755,000 times, or 755 times that of bonds.  This incredible result demonstrates the power of stocks as a long term investment vehicle.

For this reason, I recommend that any savings you don’t need in the next 5 years be placed in stocks.

You might be a little more conservative with this rule if you were approaching retirement and all of your wealth was tied up with investments.  In that situation you might then extend the time frame rule of thumb to money you don’t need in the next 5-10 years.  Keep in mind though that if you can afford to take a little more risk (like if your house is paid off and/or you have some fixed income in the form of a pension or a healthy amount of social security), on average it pays to weight your portfolio more towards stocks.

There are some important conclusions from this rule: if you’re still 5-10 years from retirement, ALL your retirement funds should be in stocks.  When you’re young, and even middle-aged, you need to be aggressive in your asset allocation by putting your wealth into stocks.  Yes, stocks go up and down a lot in the short run, but in the long run, they clearly outperform everything else.

Say you’re 30 years old and plan on retiring at 65.  If you have a portfolio that represents the entire stock market and the market gets cut in half tomorrow, should you lose any sleep?  Absolutely not!

What does it matter to you what happens to the stock market in the next 30 years as long as you insure yourself against permanent loss by having a well-diversified stock portfolio? (We’ll talk about the best way to diversify in the next article.)  All you care about is what the value of your investment is at age 65.  Anything that happens in between shouldn’t bother you one bit.  There’s an easy way to avoid this stress; don’t check your retirement balance more than once every year until you get close to retirement.  Instead, focus on what you can control and pump as much money as you can into your 401k/IRA.  (Calculate how much you’ll need to save here.)

As another ‘Stocks for the Long Run
‘ table shows below, real stock market returns have been an incredibly robust ~7% per year through periods of war, depression, oil shortages, double-digit inflation, terrorist attacks, and industry bubbles.

Hopefully by now I’ve convinced you of the absolute necessity for your long-term money to be in stocks.  That still leaves the question of short- and medium-term (< 5 year) savings.  For these savings, you want a stable investment so that you’ll know how much money you’re going to have by the time you need to use it.  As you can see below, stocks almost always outperform bonds over long time periods, but not as much over short ones.

Short-term savings (< 1-2 years): Use an online high-interest savings account like this one from INGDirect (or find one on bankrate.com.)  High-interest savings accounts typically return about 5 times the interest of a brick and mortar savings account.  Plus, ING allows you to create multiple accounts to track each of your short-term savings goals (travel fund, plasma TV, emergency money, etc.)  You can setup automatic deductions from a checking account to fund these savings goals on a regular basis.  Say you want to save $4000 for a trip to Europe one year from now.  Divide the amount of money you need by the months until you need it.  In this case, that would be $4000/12 months = $333 per month.  That’s how much you need to save each month to hit your goal.

Medium-term savings (1-5 year): If you really want to optimize your savings, use a bond index fund like Vanguard’s VBMFX for medium-range goals.  The reason for adding this complication is because bond funds typically earn a couple of percentage points more than high-interest savings accounts, in exchange for a small amount of volatility over time.

If it sounds overly complicated to have separate types of funds for short- and medium-term savings, make life easy for yourself and just use a high-interest savings account for medium-term savings goals as well.  These might include your future wedding expenses or a house downpayment.  Use the same calculation for medium-term goals as I demonstrated above for short-term ones.  These are really important (and simple) calculations to do; they often show you that you need to start saving more money each month than you already are.  (Start here to get 30 excellent tips that can save you big bucks.)


Now that you know how to allocate your assets, you need to know exactly what to invest in.  I answered that in this post for short- & medium-term investments (< 5 years.)  I showed you that for long-term investments, stocks are clearly the way to go, but the question remains, how should you go about investing in stocks?  Should you buy that hot mutual fund you read about, or maybe individual stocks like Google or Walmart; what about investing in foreign companies versus US-based ones?

Read the next article for what may be the only long-term investment choice you’ll ever need.

* Many people might clamor for real estate to be added to this list.  Contrary to popular opinion, real estate has been a terrible investment over long periods of time, appreciating roughly with inflation (ZERO real return.)  From 1975 – 2008, real estate appreciated at real return of 1% per year, versus 2% for risk-free treasury bills and 8% for stocks.  Owning property means paying many expenses like property tax, homeowner’s insurance, maintenance and large transaction fees (like closing costs of ~6% when selling your home.)  Also, real estate is very illiquid, meaning it is hard to turn it into cash; the only way to do so is to sell it.

If you needed money in a hurry you can sell your stocks anytime the market is open instantly for about $10 per trade, whereas your house could sit on the market for months and not sell.  You should treat a potential home purchase as a place to live, NOT as an investment.  Even if you plan on buying property to rent it out, you still have to play landlord, or pay someone else to do it.  Buying a stock index fund, on the other hand, allows you to sit back and do next to no work while your money grows exponentially. [Back to where you left off]

The single best investment choice – Intro to Index Funds

In my last post I showed you why your long-term investments should be in stocks.  In this post I’ll tell you about what might be the only investment choice you’ll ever need.  Before we get into that, let’s go over the various options an individual investor has for participating in the wealth-creating machine that is the stock market.

Individual stocks

Picking individual stocks can be fun, exciting, and, for those of you who love to crunch numbers, very interesting.  Unfortunately, most individuals do very poorly at picking their own stocks.  We tend to buy when everybody is saying good things about the market, when prices are high, and tend to sell when everybody is pessimistic about the market, when prices are low.  Of course, this is completely contrary to the hard-to-follow stock market aphorism ‘buy low and sell high.’  To make matters worse, you’ll be competing against highly educated professionals with loads of experience and resources.  These guys do this all day and get paid very well for it.  Chances are, they know a lot more than you.

Even if you want to try and gain competency on your own, there’s a lot of work involved.  After coming up to speed by reading a TON of material on your own, you must keep up on your stock picks at least quarterly.  You should listen in on earnings calls, read the quarterly financials as they come out, and follow important news about the company’s business prospects and any major changes in its corporate management.

For those who still want to delve into the world of individual stock picking, read my primer here.

Mutual Funds

You might decide that you don’t have the knowledge, time or interest to pick your own stocks, so you might consider paying someone else to do it.  Actively-managed mutual funds are run by professional investors who try to beat the market by picking stocks.  In return, you have to pay them via an ‘expense ratio’, which is charged as a percentage of your invested assets, generally ranging from 1-2% per year.  This means that every year 1-2% of your money goes straight into the fund company’s pockets.  In addition to fees for managing the fund, some mutual funds charge ‘loads’, which are effectively sales commissions that occur when you first buy the fund (a ‘front load’) or when you sell it (a ‘back load’.)  These are often 3-5% of assets; quite a large chunk.  If you see a 12b-1 component of a fund’s expense ratio, that means they’re passing on to you the costs of promoting and advertising their fund to other potential customers.

If all those fees sound expensive, you’re darn right!  Of course, if these highly-paid managers actually beat the market (after taking all fees into account), it would be worth it.  Unfortunately, in any given year 60 – 80% of actively managed mutual funds fail to do just that.  You might then think ‘I’ll just look for the managers that do beat the market and pick their funds’.  The problem with this is that you can only look at past performance, which is often NOT a good indicator of future performance for a variety of reasons:

1) Luck – If you take 100 mutual funds, roughly half of them will underperform the market and roughly half will overperform due to sheer random chance.  (Actually, less than half will beat the market on average due to the fees we talked about above.)  Statistically, you would even expect several funds to beat the market for a few consecutive years, again, simply due to chance.

2) ‘Survivorship bias’ – Mutual fund companies know that investors (and rating companies like Morningstar) look to past performance for an indication of future returns.  Because of this, they close down funds which show poor performance, leaving only the out performers.  When you combine this with the luck factor, you realize that these ‘survivor’ funds are no more likely than the closed, underperforming funds to outperform in the future.

To take an example, pretend you were a mutual fund company that started with 24 funds.  After year 1, 12 are up, 12 are down.  You close the down ones (replacing them with new funds) and wait another year.  After year 2, 6 of the original 12 are up, 6 are down.  Close the down 6 and wait one more year.  After year 3, three funds have outperformed the market an amazing 3 years straight!  Now you heavily tout them in every investment publication you can find, inviting many investors to buy in only to see mediocre results afterwards.

3) Fund manager turnover and ‘style drift’ – Even if you were lucky enough to find a fund manager like Peter Lynch, he might leave a fund, leaving you no better off than you were before.  Similarly, a fund manager who was successfully using ‘value’ techniques might change his investing style to something that doesn’t work for him.  Many managers during the dot com bubble couldn’t resist the allure of high-growth tech companies like Cisco and Amazon.  They bought into stocks completely outside the realm of their expertise, and as a result, their investors lost a ton of money.  This switching of investing styles is known as ‘style drift’, and can make the most conservative fund more risky if your fund manager decides to ditch blue chips in favor of Russian gold mining or that new cold-fusion-developing penny stock company.

4) The market for mutual funds is pretty efficient – Let’s say you do find a superstar fund manager, the fees he commands don’t make his fund underperform, he sticks around, AND he stays on his game for profitable investing.  Now you have a sure winner, right?  Sorry, wrong again.  Good funds quickly become well known, and as a result, their prices get bid up by all the other investors clamoring to give them money.  In an efficient market, the price of the mutual fund will get bid up to the point where its returns should be on par with the general market going forward.  In fact, studies have shown that because of this overbidding of mutual fund prices, many funds with great past performances actually underperform the market going forward because investors have overestimated the fund’s worth.

This adds the following complication to successful mutual fund picking: you have to know something the majority of the market doesn’t in order to get into a good mutual fund and expect to outperform the market.

Given all these problems, it’s easy to see why actively-mangaged mutual funds underperform the market.  Jeremy Siegel, in ‘Stocks for the Long Run‘, has shown by how much these funds fall short of market benchmarks:

If we take out the ‘survivorship bias’ discussed above, we see that over a recent 26 year period, actively managed mutual funds have underperformed the market by over 1% per year.  That might not sounds like a lot, but if you invested $10,000 in 1971 at the market’s 11.55% you’d have $171.5 K by the end of 2006.  If instead you bought a typical mutual fund, you’d have $133.8 K, nearly $38,000 (22%) less!

Not only that, but if you take taxes into account, index funds perform even better.  The reason for this is that active managers are busy buying and selling stocks which generates capital gains (short and long-term) which creates taxes for you.  These taxes, not reflected in Siegel’s chart above, further depress your returns, unless your fund is in a tax-advantaged retirement account.

Now that we’ve shown that high fees from actively-managed mutual funds result in lower returns than the market, wouldn’t it be great if you could just buy the market at a low cost?

Index Funds

John Bogle of the Vanguard company set out to make it possible for investors to do just that.  While Vanguard is still the leader in low-cost index funds, many other major fund houses like Fidelity and T.Rowe Price have followed suit, giving investors myriad index choices.

Looking at recent history, from 2002 – 2007 the S&P 500 index outperformed 71% of actively-managed large-cap funds.  The S&P SmallCap 600 and S&P MidCap 400 outperformed 64% and 80% of actively managed small- and mid-cap funds, respectively, over the same time period.

There are numerous advantages to index funds:

Low fees – Since many index funds are comparable in terms of what they invest in, you need to look at expense ratios first.  A good index fund should have an expense ratio under 0.5%, the lower the better.  Vanguard’s major stock funds are currently at 0.18%, a fraction of the typical 1-2% fee charged by active  mutual funds.

Instant diversification – In addition to low costs, broad market index funds give you instant diversification.  An S&P 500 fund, for example, allows you to purchase 500 of the largest and most recognizable firms in the United States including Google, Microsoft, Wal-mart, McDonald’s, Nike and Disney.  If that’s not diversified enough for you, try a total stock market fund like Vanguard’s VTSMX which invests in over 3,000 US companies both large and small.

In addition to broad, US stock market indexes, individual investors can buy foreign index funds, sector funds, bond funds, etc.  Even though global markets have become more and more dependent on each other, experts still recommend diversifying your stocks across countries as well.  Jeremy Siegel recommends putting at least 30% of your assets into a foreign fund.  Since indexes are ‘capitalization weighted’, which means that the bigger a company is, the more the index owns of it, some investors also like to add small cap funds to their portfolio.  If you like, you can add 10-20% of a small cap index as well.

Here’s a couple of sample asset allocation schemes you could use (with Vanguard funds as examples; here’s a more general list of popular indexes), in order of simplicity:

1) Domestic market only – Total US stock market fund: VTSMX – 100%

2) Add foreign exposure – Total US stock market fund: VTSMX – 70%; Foreign stock market fund: VGTSX (= 50% European, 25% Pacific, 25% Emerging Market)- 30%

3) Add small caps – Total US stock market fund: VTSMX – 55%; Foreign stock market fund: VGTSX (= 50% European, 25% Pacific, 25% Emerging Market) – 30%; Small Cap fund: NAESX – 15%

Simplicity – It’s a piece of cake to use index funds to build a low-fee, diversified portfolio.  Best of all, you hardly ever need to check up on it (you should within 10 years of retirement at the very least.)  Just invest regular amounts in whatever asset allocation scheme you like (see above), repeat, and retire wealthy.  In addition to stocks, you can buy a bond fund for your medium-term savings (or just go with a high-interest savings account.)


Due to the underperformance on both individual stock pickers and mutual funds, index funds are the way to go for the vast majority of investors.  Even those who are very knowledgeable about financial markets do well to ignore the Jim Cramer’s of the world and focus on consistently building long-term wealth through a diversified portfolio of stock index funds.

“Over the [past] 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous.”

Warren Buffett [courtesy of MoneyChimp.com]

[Check back later for an article on Exchange-Traded Funds (ETFs), which are another way to buy indexes, and a calculator to decide whether to buy the index fund or the equivalent ETF.]