I’m most definitely a Warren Buffett fan. I love it that arguably the most successful active investor alive recommends index funds, long holding periods and minimizing fees. And I love that Buffett walks his talk about being greedy when others are fearful.
During the real estate/financial collapse, for instance, he was buying more stocks while the vast majority of Wall Street was dumping them faster than rotten food. Still, even a fan like me might have a point or two with which I take issue.
Investors Should Own S&P 500 Index Funds
Warren Buffett often extols the many merits of the S&P 500 Index fund. In the most recent Berkshire Hathaway Annual Report, Buffett reveals the data on his 10-year bet that the S&P 500 Index total return would best hedge funds. With nine of the 10 years now history, let’s just say the hedge fund managers are losing in a rout.
Buffett often recommends the S&P 500 Index fund, but why? It’s flawed in a couple of respects. First, it misses out on the thousands of U.S. companies not in the S&P 500. I’m a dumb-beta investor, as factors such as size and value are no free lunch—the excess expected return is compensation for taking on more risk. This is not to say I want to ignore small and midsize companies.
The second flaw of an S&P 500 Index fund is its popularity. Any new entrant to the S&P 500 Index comes at an inflated price. Every S&P 500 Index fund will buy only after the price has gone up, since investors inflate the price knowing billions of dollars of the stock must be purchased when a company is added. Conversely, any company being booted from the S&P 500 Index will likely suffer a price decline before the S&P 500 Index fund dumps it.
Thus, a total stock index fund is better—it’s just as low cost, and even more tax efficient. And while we’re at it, why stop at the U.S.? Global economy and international stock index funds have a role as well.
Avoid Or Use Bonds Sparingly
Buffett has not been all that bullish on bonds for quite some time. He has said a portfolio could comprise 90% S&P 500 Index fund and 10% short-term government bonds. I question why such a small percentage in bonds, and why short-term. My portfolio is 55% fixed income, and virtually all is intermediate-term. I do agree with him on the “government” part, as most of my fixed income is backed by the U.S. government, the only entity licensed to print U.S. dollars.
The reason I own so much in bonds is because they have less volatility in a year than my stock portfolio has in a day. My need to take risk is low, so boring bonds need only keep up with inflation to fund my family’s lifestyle.
Two bonuses are that they have so far bested global stocks this century, and they performed well during both the dot-com and real estate bubbles, which allowed rebalancing. Junk bonds didn’t serve this role.
Why would one buy anything other than short-term bonds with rising rates? Because the top economists have a horrible track record of predicting the direction of interest rates. No one knows anything more about rates than the fact that the Federal Reserve plans to raise the Fed Funds rate, which is only the overnight rate. The market controls longer-term rates. Also, it’s easy for individuals to earn higher returns with less risk using bank CDs.
I so admire Warren Buffett for all he has done to help investors avoid fees and emotional mistakes. I also totally agree with his praise of John Bogle. But while owning the S&P 500 is good, owning the world is better. And high-quality intermediate-term bonds and certificates of deposit serve critical roles in portfolios.
At the time of writing, the author owned S&P 500 index funds, total stock index funds, total international stock index funds, total bond funds and CDs. Allan Roth is founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning magazine. You can reach him at [email protected] or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter