Amending Warren Buffet’s Golden Rule

One of the more damaging pieces of advice to the average investor is Warren Buffet’s famous investment rule:

“Rule No. 1: Never lose Money. Rule No. 2: Never forget Rule No. 1”

While this folksy wisdom has a great ring to it, it can be easily taken out of context. I think what Buffet is trying to say is not to gamble with your money and be prudent in your decision making. Many investors read this rule and believe that they should literally attempt to not lose money when they invest. Over the past 20 years, Buffet’s own company, Berkshire Hathaway, has had 6 losing years, with one of them erasing approximately 1/3 of his shareholder’s value. That means over the last 30 years, he has broken his own rule 30% of the time!

Investing involves risks. Those risks aren’t just theoretical. Historically, the stock market goes down around 1 out of every 3 years. For those who are trying to follow Buffet’s rule, how are they going to deal with this simple fact? Unfortunately, we tend to see it manifest itself in market timing, the act of trying to get in and out of the market at the right times. No one we know of has been able to do this consistently enough where you could attribute their performance to skill versus just plain luck. Buffet himself eschews the practice of market timing. He once wrote that his, “favorite holding period is forever”.

Those investors who want to follow Buffet’s rule have three strategies they can lean on to help them implement this idea of not losing money:

  1. Time period- over one year periods, the stock market has negative returns about 30% of the time. Conversely, there has never been a 20 year period in the S&P 500 where returns have been negative. The longer time you have, the lower the probability of losing money.
  2. Diversification- when you buy one or two companies, the risk of loss is high. In fact, we wrote about this in a prior post. Since 1983, 39% of all publicly traded stocks have lost money. You must spread out your bets to ensure you don’t pick one or two losers that can cause permanent losses.
  3. Discipline- there will be bad times. Probably the easiest way to violate Buffet’s rule is to sell your investments AFTER a loss. Having the discipline to stick with your investment strategy after a difficult period is a key factor in avoiding permanent losses.

I think amending Buffet’s rule would be immensely helpful. Here is how I would word it:

“Rule No. 1: Don’t lose money, permanently. Rule No. 2: Never forget Rule No. 2”

By implementing the three strategies we’ve listed above you have a much better chance of following that rule.

Some Things Never Change…

The sun rising in the east, human ingenuity, the changing of the seasons, wars, and conflicts in the financial services industry.  These are just a few things that will never change.

I joke, but not really.  I hesitate to say that this new story was shocking, since it is something I've now come to expect:  Morgan Stanley Purges Vanguard Mutual Funds.  It is not at all uncommon for a brokerage firm to remove a fund company from its platform, but in this instance, when you read the reason why you'll probably be as upset as I was:

Brokers and consultants said that Morgan Stanley is almost certainly retaliating against Vanguard because of the Valley Forge, Pennsylvania-based firm’s longstanding refusal to pay for brokerage firm “shelf space” as part of its crusade to keep expenses for investors low.

With all of the "fiduciary" talk continuing to pick up steam, Morgan Stanley (and Merrill Lynch who is also mentioned in the article) have decided to not allow the largest fund company on the planet to offer its funds on their platform.  Not because of poor performance or high risk to shareholders, but because they wouldn't pay-to-play.  Because Vanguard's mission of keeping costs low for shareholders cannot co-exist with Morgan Stanley's need to make a profit.  And our industry wonders why we get a bad reputation?  This is exactly the reason we started Greenspring 13 years ago.  Several of us left the organizations mentioned in this article because we wanted to do what was in our client's best interest.  That often times could mean investing in the lowest cost mutual funds on the market.  Now Morgan Stanley is saying that won't be possible.  As we've said before, if you work with a broker at one of these groups, they are not necessarily bad, but the system is set up against you.  Don't hate the player, hate the game.

 

 

The Reward For Good Behavior

Many investors have been educated on the broad investment themes to improve their investment experience and outcomes. Some of the most basic include asset allocation (this determines the vast majority of both the risk and return of your portfolio), broad asset class diversification to reduce the overall portfolio volatility, and more recently lower cost mutual funds to improve the probability of better investment results compared to higher cost funds.

One of the most common concerns that clouds an investor’s vision of a comfortable retirement with large account balances or plenty of asset class diversification with sufficient retirement income is the inevitable equity market downturn. It has been eight years since the U.S. equity markets have had a significant correction and investors should be reminded and prepared for the eventual decline that comes with equity investing.  In fact, since 1929, there have been 25 bear markets (defined by a 20% loss or more).  On average, that means a bear market occurs approximately once every 3.5 years.  If history is any guide, most of us are going to experience several bear markets over our lifetime.

The future is uncertain and investing is often influenced by unexpected events, some good and others bad. Predicting when or how bad the next correction will be is futile but you can be prepared for it. Behavioral coaching is most effective when clients are prepared for the eventual ups and downs of the markets and prepared in advance of such unexpected events.

This is exactly when advisor behavioral coaching with clients is most important. Human emotion and fear can allow clients left to their own choices to abandon their financial plan and run for cover. Advisors use their past experiences to bring logic, patience and discipline back into focus for client conversations. Clients must realize and accept these downturns as part of the investment journey.  The reward for accepting this truth is gigantic.  Over the 87 years (from 1929 to 2016) that I quoted above, an investor who kept their money in the S&P 500 would have seen $1,000 grow to over $2.7 million.  It is important to note, that to generate this return they would have experienced 25 bear markets, everyone different in their own right!

Saying you need to be prepared and actually experiencing the next downturn can be challenging. What can you do to prepare? Here are several ideas. First, recognize that market declines will happen.  The sooner that you accept that you can’t control that piece of investing, the better you will be able to handle the short-term volatility when it occurs.  Second, review your asset allocation model and be prepared to rebalance if certain asset classes are either overweight or underweight versus their target allocations. Third, think about how much money do you have saved in your “rainy day bucket”? Clients could consider these cash reserves as their “first source of funds” when markets correct so they can avoid selling assets as they are declining in value. Finally, maintain balance in your portfolios and life. Broad asset class diversification can help reduce volatility in your portfolios. As it relates to your day-to-day life, turn off the news, stop looking at the declining asset values on-line or statements and go on with your life and trust that markets will once again have better days.

Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.