At the bottom of the Berkshire Hathaway 2016 Annual Report, you may not have noticed that Warren Buffett republished a previous article from the 2005 annual report titled “How to Minimize Investment Returns”. A version become the first chapter (find it here) of The Little Book of Common Sense Investing by Jack Bogle. I am jumping on the bandwagon and republishing this 2007 blog post below as well. 🙂

It’s both a highly recommended parable and it comes at the perfect price of free. Read it if you haven’t already.

Original post:

I just watched the Will Smith movie The Pursuit of Happyness this weekend. I found it ironic that he really didn’t change job types when he joined Dean Witter. Mr. Gardner started out a salesman, and ended up a salesman. But by managing to change his product to financial services, he turned his tenacity and people skills into millions of dollars.

Why is financial services such a lucrative field? This reminded of an excerpt that I had saved from Warren Buffett’s 2005 Letter to the shareholders of Berkshire Hathaway. Although a tad on the long side, I think it provides an excellent “big picture” view of investing the the stock market.

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Berkshire Hathaway (BRK) released its 2016 Letter to Shareholders [pdf] over the weekend. Although the financial media will create some catchy headlines, I recommend reading it for yourself. It is only roughly 30 pages long and is always written in a straightforward and approachable fashion. Even if you aren’t interested in BRK stock at all, reading the letter can be educational for individual investors of any experience level. Here are my personal notes and comments.

Bullish on America. This is a repeated theme from past shareholder letters.

From a standing start 240 years ago – a span of time less than triple my days on earth – Americans have combined human ingenuity, a market system, a tide of talented and ambitious immigrants, and the rule of law to deliver abundance beyond any dreams of our forefathers.

[…] This economic creation will deliver increasing wealth to our progeny far into the future. Yes, the build-up of wealth will be interrupted for short periods from time to time. It will not, however, be stopped. I’ll repeat what I’ve both said in the past and expect to say in future years: Babies born in America today are the luckiest crop in history.

Berkshire Performance. Another topic that has been touched upon before is that Berkshire is huge and you shouldn’t expect the amazing results from when they were much smaller (19% annualized over the last 50+ years). However, they still plan on beating the S&P 500 over the long-term. If they didn’t, they’d tell their shareholders to move their money elsewhere.

As for Berkshire, our size precludes a brilliant result: Prospective returns fall as assets increase. Nonetheless, Berkshire’s collection of good businesses, along with the company’s impregnable financial strength and owner-oriented culture, should deliver decent results. We won’t be satisfied with less.

According to Morningstar as of 2/24/17, the trailing 10-year total return for BRKA is 9.1% annualized. The trailing 10-year total return for the S&P 500 index is 7.5% annualized. Not bad. (I should also disclose here that I own Berkshire (BRKB) shares in my separate “self-directed” portfolio which is a small percentage of net worth.)

Berkshire Fair Price. Another repeated theme. Buffett is authorized to repurchase large amounts of Berkshire shares at 120% or less of book value. In other words, 1.2x book price is a significant discount to Berkshire’s intrinsic value. If you’re getting close to that number, BRK is probably a “good deal”.

Stock holdings: Not necessarily buy-and-hold forever. This year, Buffett chose to emphasize that he has never promised to hold any particular stocks forever. (It does have no interest in selling its wholly-owned and controlled businesses.) Perhaps it is because he just bought shares of American, Delta, Southwest, and United Continental airlines. The airline industry has quite a rocky performance history. Perhaps it also to explain him selling all of his Wal-Mart shares.

Hedge Fund Bet. You’ve probably heard about this 10-year bet between the S&P 500 and a bunch of hedge funds. Here is my 2016 hedge fund bet update. The short version is that with 9 years down and 1 left to go, the S&P Index fund is up 85%. Of the 5 hedge funds (of funds), the worst hedge fund is up only 3%. The best hedge fund up only 63%. Buffett and the S&P 500 are very likely to win this bet.

I found it noteworthy that Buffett focused on the fact that no other hedge fund manager wanted to take the bet at all. Think about that. Only one guy was brave enough to step up, and how he’s getting bad publicity.

Subsequently, I publicly offered to wager $500,000 that no investment pro could select a set of at least five hedge funds – wildly-popular and high-fee investing vehicles – that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees. I suggested a ten-year bet and named a low-cost Vanguard S&P fund as my contender. I then sat back and waited expectantly for a parade of fund managers – who could include their own fund as one of the five – to come forth and defend their occupation. After all, these managers urged others to bet billions on their abilities. Why should they fear putting a little of their own money on the line?

What followed was the sound of silence. Though there are thousands of professional investment managers who have amassed staggering fortunes by touting their stock-selecting prowess, only one man – Ted Seides – stepped up to my challenge. Ted was a co-manager of Protégé Partners, an asset manager that had raised money from limited partners to form a fund-of-funds – in other words, a fund that invests in multiple hedge funds.

Buffett used to run a partnership where he would take a zero management fee and 25% of profits above a 6% annual return. Hedge fund managers today take 2% of assets annually no matter what and 20% of all positive returns. As usual, in this WSJ article Munger tells it straight:

When Mr. Buffett ran his investment partnerships in the 1960s, he charged no management fees and only took 25% of investment gains after the first 6%. Berkshire Vice Chairman Charles Munger praised that fee model earlier this month at the annual meeting of Daily Journal Corp., where Mr. Munger is chairman.

“I think it is fair and I wish it was more common,” he said of Mr. Buffett’s fee formula. “If it’s a bad stretch, why should you scrape money off the top?”

Rarity of skilled stock pickers. If anyone could identify another good stock picker, it would be Warren Buffett. I don’t recall seeing this claim before:

There are, of course, some skilled individuals who are highly likely to out-perform the S&P over long stretches. In my lifetime, though, I’ve identified – early on – only ten or so professionals that I expected would accomplish this feat.

Best book of 2016. I am currently listening to the Audible version of Shoe Dog by Phil Knight and it’s quite good so far. I’m only at the beginning where he bootstraps his shoe business from his parents’ basement and has the guts to fly all the way to Japan in the 1960s to ask for import rights in person. This book works really well as an audiobook.

The best book I read last year was Shoe Dog, by Nike’s Phil Knight. Phil is a very wise, intelligent and competitive fellow who is also a gifted storyteller.

Shareholder letters from 1977 to 2016 are available free to all on the Berkshire Hathaway website. You can also purchase all of the Shareholder letters from 1965 to 2015 for only $2.99 in Amazon Kindle format. Three bucks is a very reasonable price to have an official copy forever stored in electronic format. (Updated paperback will be re-stocked in mid-April for about $20. Don’t overpay for a stale physical copy.)

The 2015 Annual Letter discussed his optimism in America and his “Big 4” stock holdings. The 2014 Annual Letter discussed the power of owning shares of productive businesses (and not just bonds). The 2013 Annual Letter included Buffett’s Simple Investment Advice to Wife After His Death.

As a follow-up to my post on the risks of investing in bonds, I should share that a slight majority of my personal bond holdings are in short-term and intermediate-term municipal bonds. Why? Well, here are some considerations if you are choosing between holding highly-rated municipal bonds and US Treasury bonds right now.

The Blackrock Blog has an article discussing potential effects of tax reform on muni bonds and also their latest Municipal Market Update [pdf]. Here is my interpretation of their points:

Lower individual tax rates would reduce the value of tax-exempt mutual fund income. However, the tax equivalent yield (TEY) of municipal bonds would likely remain higher than that of Treasuries. The calculation is straightforward. For example, at a 28% marginal tax rate, if a municipal bond earned 2%, that would be a tax-equivialent yield of 2/(1-0.28) = 2.78%. Here’s the chart from Blackrock:

It is highly unlikely that the tax-exempt status of municipal bonds will be removed. State and local government need low-cost muni bonds to finance improvements in infrastructure. It is possible that the tax-exemption could be capped, but even in that case the market impact would be manageable.

Here’s the ratio of AAA-rated GO Muni bonds to Treasuries over the last 12 months (Source). As you can see, the ratio hovers around 90% to 95% without compensating for taxes.

Here is a chart of the muni and Treasury bond curves as of 1/31/17:

Their overall conclusion:

We also expect any market correction required to overcome a drop in the highest tax rate or cap on the tax-exemption would be manageable, and continue to believe munis hold an important place in a diversified portfolio.

Purely my opinion… I don’t bother speculating on future tax reform. I’m not an economist, so I can admit that I don’t know the future. I do know that even in the 25% or 28% marginal tax brackets, right now the tax-equivalent yields of muni bonds are higher than Treasuries by a significant gap. At higher marginal tax brackets, the gap widens further (again, see top chart above).

Municipal bonds are not considered as safe as US Treasuries, and smart people can argue as to how close the risk levels are. I personally think the yield gap is greater than the risk gap, enough that I’d rather be in munis, but others may disagree. Why would this happen in a mostly “efficient” market? My personal view is that the entire world (including entire countries and sovereign funds) relies on US Treasuries as their “safe and liquid” asset, pushing yields downward, while the benefits of muni bonds are only available mostly to US individual taxpayers.

Sometimes I think I should just buy a “total bond” fund (tracks all taxable, nominal US investment grade bonds) and forget about it. But then I look at the yield difference. As of today 2/21/17, Vanguard Total Bond Index has an average duration of 6.1 years and 2.50% yield. Vanguard Intermediate Tax-Exempt has an average duration of 5.2 years and 2.07% yield (tax-exempt). At 28% federal tax rate, that is equivalent to 2.88% taxable. At 43.4%, that is equivalent to 3.65% taxable. (These numbers are for Investor Shares; the gap is even bigger if you have $50,000 and can buy Admiral Shares.) Add in the fact that I have limited space in tax-deferred IRAs and 401(k) accounts, and all this is why I pick munis for my taxable accounts.

To get the full return of any asset class, you’ll have to own it through the good times and the bad times. The good times are easy, but getting through the bad times requires deeper understanding and faith. You’ll usually hear this about holding stocks through their inevitable drops and crashes. But recently, many bond funds have dropped in value instead. Here’s a somewhat-reassuring chart from A Wealth of Common Sense comparing historical drawdowns between the S&P 500 stock index and 5-Year US Treasury bonds:

Even so, having an investment that is supposed to be “safe” wobble 5% can still be worrisome. If Bank of America or Chase Bank announced tomorrow that their customers with balances above FDIC limits would lose even 1% of their excess deposits, there would be a huge crisis due to the perceived level of safety. A recent post by Longboard Funds makes an interesting claim: “…investors destroy more of their bond returns than their stock returns.”

This statement reminded of my surprise when reading this Bogleheads forum post on 11/14/16:

Bonds have been dropping every day [recently…]
Why? I thought they were a stable fixed investment.

S/he wasn’t alone, and I received a couple of similar e-mails, but I was struck that this person had been a member of the forum for over 2 years, made over 600 posts, and had previously detailed their asset allocation very specifically: “Brokerage account 65/35 | VG total Market 35% | VG total Intl 12% | VG small cap value 12% | VG Reit index 6% | VG Total Bond 35% | TSP Account 75/25 | C Fund 45%, S 15%, I 15%, G 25% | EE Bonds = Emergency Fund” Why did they buy all these things? No doubt from reading a lot of well-meaning advice from well-meaning people.

Bonds can certainly go down. There are also many different types of bonds. Longboard Funds put the two major risks of bonds into a nice graphic:

This won’t be a bonds primer, but instead I offer up how I try to treat bonds as part of my investment portfolio:

• I own bonds as a ballast and diversification element in my portfolio. (I also own stocks for inflation-beating growth.) I want relatively low volatility, but there will still be some based on credit and duration risk. I will take a little bit of each type of risk, but not too much.
• I also own bonds for modest income. I will be satisfied earning only modest interest rates that will roughly match inflation over the long run, and be happy if I earn 1% or 2% more than inflation.
• In order to take on a small amount of credit risk, I will stick to US Treasury bonds, investment-grade corporate bonds, and investment-grade municipal bonds.
• In order to take on a small amount of interest rate (duration) risk, I will stick to bond mutual funds with a relatively short duration (less than 5 years). The term “intermediate” could mean anything from 2 years to 10 years, so I’ll have to be careful. As a result, I will be less-exposed to short-term losses if interest rates rise quickly.
• In order to reduce the risk of any single bond default, I will own a large number of bonds inside a mutual fund or ETF. An exception would be individual US Treasury bonds as they all share the same, highest credit quality available.

Someone else may want to pursue higher bond returns and be willing to take on more risk. You could buy bonds from countries with shakier credit ratings. You could buy bonds from riskier companies. You could buy bonds with longer duration/maturities.

If you look again at that top chart, you can see several drawdowns of around 5% for a 5-Year Treasury. But what about a 20-Year Treasury, or 5-Year Junk Bonds, or international bonds from Argentina or Venezuela? It’s possible for some bond funds to drop 10% or more. If you are buying bonds because you think they are safe, stick to the safer bonds and realize that even they might still drop in price for a while.

A new academic paper was recently published with a confusing yet provocative title: Do Stocks Outperform Treasury Bills?. Of course they do… right? An excerpt from the abstract:

Most common stocks do not outperform Treasury Bills. Fifty eight percent of common stocks have holding period returns less than those on one-month Treasuries over their full lifetimes on CRSP. […]

But everyone knows stocks return more than cash. How does this work? Taken altogether, stocks outperform cash. But if you picked any individual company, your results can vary from total bankruptcy to extraordinary wealth. The paper found that if you pick an individual company and held it over its lifetime, it would be more likely than not to underperform a 4-week T-Bill (classified as a cash equivalent). You can use the T-Bill as an approximate tracker of inflation.

Wes Gray points out at Alpha Architect that this idea has been explored before. Here’s a chart of the distribution of total lifetime returns for individual U.S. stocks. The research is done by Blackstar Funds, via Mebane Faber at Ivy Portfolio.

The U-shaped distribution shows that there are a lot of big losers and a lot of big winners. Actually some are huge winners. In the end, a small minority of stocks have been responsible for virtually all the market’s gains.

Here we see that out of the 26,000 stocks studied, these 10 stocks below have accounted for 1/6th of all the wealth ever created in the US stock market.

I should reiterate that these are lifetime returns, from when they appeared in the CRSP database until now or whenever they liquidated. Unless you bought these stocks essentially at IPO (or 1926 when the database starts), you probably didn’t get these returns. If you go out and buy a well-established company today, your distribution of returns will likely look different. You’d be less likely to go bankrupt but also less likely to make a 20,000% return.

If you take a step back, as Larry Swedroe points out, this means it is technically quite easy to outperform an index fund. You simply either (1) avoid investing in a few big losers or (2) invest extra in a few big winners. That’s it! Gotta be easy to filter out a few duds, right? Yet, the lack of outperformance on average by professional managers continues, and the managers that outperform can’t be predicted ahead of time. So you can keep looking for the needles in the haystack, or you can buy the whole haystack.

Howard Marks released another Oaktree memo earlier this month that somewhat coincides with this weekend’s Super Bowl. Inside, he revisited the New York Post NFL Bettor’s Guide, a panel of “experts” offering their opinion of winning picks for each NFL game during the season. The picks are relative to the point spread offered by the bookmakers. The experts further specify up to three “best bets” each week.

Here were the results after the 2015 NFL Season (from last year’s memo):

Here were the overall results after the 2016 NFL Season:

• The best picker was right 55.1% of the time.
• The worst picker was right 48.8% of the time.
• On average the pickers were right 51.6% of the time.

In terms of the “best bets” only:

• The best picker was right 62.7% of the time.
• The worst picker was right 43.1% of the time.
• On average the pickers were right 54.0% of the time.

Here’s my take on the observations in the memo:

All results cluster closely around 50/50. A blindfolded squirrel (or me flipping a coin) could easily blend in with this panel of “experts”. Some do a bit better than 50/50 (but not much better), while others do a bit worse (but not much worse). This is exactly what the distribution of a high number of coin tosses looks like. It’s very hard to consistently beat the point spread created by the “market” consisting of other bettors.

Don’t forget the vigorish. When you place a bet with a sports book, they charge a fee (“the vig”) for their services. For example, you may have to bet $110 to win $100. That translates to a roughly 5% commission on each bet. Even if you were right on average 54% of the time, you would still lose money in the long run after fees.

These are results from people who are paid to observe, analyze, and write about football games. Yet their performance could be mostly explained by luck, and even any slight outperformance on average is more than negated by fees.

In terms of investing, there are also many “experts” willing to offer their opinion on winning stock picks or other financial forecasts. Most will be average, or perhaps even slightly above average. However, history (and common sense math) shows that their performance won’t be good enough to offset the higher fees that they charge. In addition, there is no surefire way to find these above-average pickers ahead of time (using past performance doesn’t work). Due the presence of such fees, you can guarantee yourself “above average” net results by simply buying low-cost index funds.

I’m not one of those people that completely dismiss the possibility of skill in investing, but you if do want to go that route you should be realistic. If you’re picking your own stocks, keep an honest tab on your performance. If a mutual fund is charging 1.5% annually today to actively manage US stocks, it is rather unlikely that it will outperform a low-cost US stock index fund in the long term. On the other hand, an actively managed mutual fund that charges 0.15% annually and has various other positive factors has a more reasonable chance of slight outperformance. However, at the same time you must also accept the possibility of slight underperformance.

Jack Bogle is rightfully respected and there are probably over a hundred mentions of his name on this site. His message of common sense, simple, low-cost investing continues to spread since he first opened the Vanguard 500 Index fund to the public in 1975. Yet, he still has to keep pounding his drum because there is so much other noise out there. Similar to the sketches of NYT journalist Carl Richards, I present to you what I call the Bogle Appreciation Curve.

The overall shape of this curve can probably be applied to any field where there are classic fundamentals and then a bunch of fancy stuff on top. It definitely applies to investing, where there is an insatiable desire for something newer, better, and more complex.

Beginner Investor. You’re just starting out, and you read some recommended business books. There’s the classic Bogle on Mutual Funds and the much shorter one called The Little Book of Common Sense Investing (which you picked) by Bogle that really made sense and sounded reasonable. You see why low-costs and passive investing are based on common sense and basic mathematics. You understand why you should avoid high-cost, high-turnover funds sold by brokers.

Investor Who “Knows Things”. You read more about investing, learning about correlations and factors and portfolio optimization. This stuff is pretty interesting! Historically, if I bought a nice slug of “small-cap value” stocks, a bit of commodities, a sprinkle of gold, I would have higher returns with less volatility? I’d do even better with a momentum-following strategy, and now there is a smart beta ETF that will do it for me? It seems so easy to do better than a “vanilla” portfolio.

Jack Bogle says “smart beta is dumb”. Hmm, maybe he’s just not with the modern times anymore.

Older, Humbled Investor. Well, that was exhausting. The historically optimal portfolio in 1990 wasn’t the same as the historically optimal portfolio in 2000, and that was again true in 2010 and will be again in 2020. I missed out on part of the 2008-2016 surge because people told me the market was overvalued due to CAPE and PE10 and many other metrics. If I had just stayed the course through it all, I’d have done pretty good. I think someone told me to keep it simple. Who was it? Oh yeah, Jack Bogle. I need to re-read his books.

You can also keep up with John C. Bogle’s media appearances on his personal website. The updates serve as a nice, regular dose of Bogle wisdom.