Warren Buffett’s Annual Report

If you’ve never taken the opportunity to read Warren Buffett’s annual letter to Berkshire Hathaway shareholders, I highly recommend it.

While I strongly disagree with Warren on many national policy issues, his investment philosophy and process are sensational and worthy of careful attention by all of us.

In his 42 page letter, he dissects the performance of all of the Berkshire’s companies which is fascinating.  You can’t help but marvel at the depth of thinking that goes into each of their holdings.

Warren is also refreshingly forthcoming about his mistakes.  While his overall long term investment track record is spectacular, he has made his share of mistakes and he spells several of them out for his shareholders with brutal honesty.

Rather than summarize the entire letter, which is well worth reading, I want to provide you with an excerpt from page 18 on risk and volatility that says it all.

I strongly recommend having a yellow highlighter in hand while you read this:

“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, with reinvested dividends, generated an overall return of 11,196%.  Concurrently, the purchasing power of the dollar declined a staggering 87%.  That decrease means that it now takes $1 to buy what would be bought for 13 cents 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 50 years is that is has been far safer to invest in a diversified collection of American businesses than to invest in securities – Treasuries for example – whose value has 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 – …..any party that may 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 lifetimes.  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 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 investors’ 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.”

As shampoo bottle instructions have always said: “Shampoo, Rinse, Repeat.”

My recommendation for this excerpt: “Read, Pause for Reflection, Read again!”

This is bulletin board material for all of us to read almost on a daily basis!