Hello Everyone,
Over the weekend Berkshire Hathaway’s Chairman’s Letter to Shareholders came out and as usual it was a must-read. There are numerous fabulous points on it so it if you get the time read it, but I wanted to direct your attention to an excerpt on the reality of risk versus the perception of risk. The worst mistake investors make is focusing on short-term results, instead of taking a long-term value-based approach. Also, when investors mistake volatility for risk, they are doing themselves a massive disservice as that volatility is what sets the stage for the best opportunities. How this relates to TTCM is quite simple. Looking at the U.S. right now there are several themes at work. One longer-term theme has been huge changes to financial regulation and oversight, which combined with low interest rates has many financial stocks near all-time lows from a price/book perspective. While the stocks have gone up the valuations, really haven’t because they have been increasing their book values commensurate with the increase in price.
In addition we have added exposure to the energy sector, which is in a period of incredible distress, including small investments in Russia, which is in an absolute depression due to sanctions and the lower oil prices. Over the short-term it is very difficult to forecast where these investments will trend, but it is difficult to imagine a situation where 3-5 years out, we don’t make a large amount of money because of the incredibly cheap prices that we are buying the companies at. Contrast this with fixed income such as Treasuries, where any increase in interest rates can have a devastating impact on bond prices and where there is very little reward in the first place. “Blue Chip” yield-oriented investments such as REITS, consumer staples and utilities trade at valuations that vary from 25-50% higher than historical averages. This is where the real risk is and it will be very difficult to protect capital or earn money with the prices that are being paid for many of these types of companies. That is real risk, despite the lower volatility these stocks have shown over the short-term. I’ll let Buffett do the rest of the talking and I hope that you enjoy!
From Berkshire Letter:
Our investment results have been helped by a terrific tailwind. During the 1964-2014 period, the S&P 500 rose from 84 to 2,059, which, with reinvested dividends, generated the overall return of 11,196% shown on page 2. Concurrently, the purchasing power of the dollar declined a staggering 87%. That decrease means that it now takes $1 to buy what could be bought for 13¢ in 1965 (as measured by the Consumer Price Index).
There is an important message for investors in that disparate performance between stocks and dollars. Think back to our 2011 annual report, in which we defined investing as “the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future.”
The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities – Treasuries, for example – whose values have been tied to American currency. That was also true in the preceding half-century, a period including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain to be repeated during the next century.
Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.
It is true, of course, that owning equities for a day or a week or a year is far riskier (in both nominal and purchasing-power terms) than leaving funds in cash-equivalents. That is relevant to certain investors – say, investment banks – whose viability can be threatened by declines in asset prices and which might be forced to sell securities during depressed markets. Additionally, any party that might have meaningful near-term needs for funds should keep appropriate sums in Treasuries or insured bank deposits.
For the great majority of investors, however, who can – and should – invest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities.
If the investor, instead, fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risky things. Recall, if you will, the pundits who six years ago bemoaned falling stock prices and advised investing in “safe” Treasury bills or bank certificates of deposit. People who heeded this sermon are now earning a pittance on sums they had previously expected would finance a pleasant retirement. (The S&P 500 was then below 700; now it is about 2,100.) If not for their fear of meaningless price volatility, these investors could have assured themselves of a good income for life by simply buying a very low-cost index fund whose dividends would trend upward over the years and whose principal would grow as well (with many ups and downs, to be sure).
Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to “time” market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy. Indeed, borrowed money has no place in the investor’s tool kit: Anything can happen anytime in markets. And no advisor, economist, or TV commentator – and definitely not Charlie nor I – can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet.
The commission of the investment sins listed above is not limited to “the little guy.” Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades. A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game.