Despite the garbled cacophony of market punditry that washes in and out of the news media like the tide, there’s actually a straightforward way to achieve satisfactory investment results. This, at least, is the argument offered by Berkshire Hathaway (NYSE:BRKA)(NYSE:BRKB) Chair and CEO Warren Buffett, who is perhaps chief among those wise and savvy men and women who make up the pantheon of legendary investors.
“You don’t need to be an expert in order to achieve satisfactory investment returns,” Buffett wrote in his 2013 letter to shareholders. You don’t even need to spend your time seeking obscure information advantages in the archives of the Securities and Exchange Commission or looking for enlightenment in academic financial literature (unless this kind of nose-to-the-grindstone pass time is your cup of tea, in which case, sláinte!)
The basis for Buffett’s argument is this: “In aggregate, American business has done wonderfully over time and will continue to do so (though, most assuredly, in unpredictable fits and starts.) If this is true (and why shouldn’t it be), then the “goal of the non-professional should not be to pick winners — neither he nor his ‘helpers’ can do that — but should rather be to own a cross-section of businesses that in aggregate are bound to do well.” After all, what could be a more satisfactory investment result than a replication of the growth of the market at large?
There is, of course, an echelon of money managers whose job it is to do just the opposite — to buck the index, identify winners and losers, and therefore outpace the market. But this is a game best left to those with an appetite for risk, because most of the players will fail. This is a point Buffett and others have argued, convincingly, for decades.
For the rest — the vast majority of people looking to invest in their retirement or in their children’s college education — step back and don’t treat the market like a game. Treat it as a mechanism to facilitate investments into debt and equity that will help you grow your wealth.
“My money, I should add, is where my mouth is,” Buffett adds in his letter to shareholders. “What I advise here is essentially identical to certain instructions I’ve laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife’s benefit …. My advice to the trustee could not be more simple: Put 10 percent of the cash in short-term government bonds and 90 percent in a very low-cost S&P 500 index fund.”
Buffett even goes as far as to recommend one: Vanguard’s S&P 500 index fund (NYSEARCA:VOO). For about $170 (market price as of March 26, 2014) investors can own a slice of the entire S&P 500. Moreover, the fund has an expense ratio of just 0.05 percent, pretty much the lowest fee you can find.
Vanguard’s S&P 500 ETF is about as vanilla as an investment as you can get, which is to say that it will do the trick, but it’s not very interesting. There’s nothing wrong with this — it’s generally better to avoid thrill-seeking while investing — but there’s also nothing wrong with exploring some more targeted investments, which can be done while still applying the same general lesson spelled out by Buffett. In fact, an investor can even seek to replicate the same broad strategy that has worked so well for Buffett. Here’s a couple of angles to pursue.
1. The financial sector
During the late-2000s crisis, Buffett bet big on the U.S. financial sector — really, really big. When the financial markets seized, Buffett made white knight investments in banks like Goldman Sachs (NYSE:GS) and Bank of America (NYSE:BAC) as well as in financial institutions like GE Capital (NYSE:GE) to the tune of $24 billion. He traded them cash for preferred stock, which typically paid enormous dividends, as well as purchased warrants for common stock.
Buffett’s position in the financial industry didn’t begin with the crisis, though. Berkshire first took a position in Wells Fargo (NYSE:WFC) in 1990, and that position has since grown to be the company’s largest holding. When asked about his stance on the financial industry, Buffett’s response is generally characteristically straightforward.
“The banks will not get this country in trouble,” Buffett told Bloomberg’s Betty Liu early in 2013. “I guarantee it. The capital ratios are huge, the excesses on the asset side have been largely cleared out.” At the time, Buffett had multibillion dollar investments in four of the seven largest U.S. lenders by assets. “Our banking system is in the best shape in recent memory,” Buffett told Bloomberg.
Taking a big bet on individual banks can be risky, but if you believe the industry as a whole is positioned for outsized returns then you can make that bet through ETFs like the Financial Select Sector SPDR Fund (NYSEARCA:XLF), which actually owns a sizable portion of Berkshire stock and runs an expense ration of 0.18 percent.
2. Big chunks of earning power
In an interview with CNBC at the beginning of March, Buffett said that, “Our preference at Berkshire is to keep buying big operating businesses. In terms of building Berkshire for the long-term, we just like adding earning power, big chunks of earning power.” What could be better than that?
This comment was made in the wake of two major purchases in 2013. First, Buffett purchased a major interest in H.J. Heinz, a food processing company with deep roots in the United States. Berkshire was the financing partner in the deal, working with 3G Capital, a multinational long-term value creation investment firm run by Jorge Paulo Lemann, who, like many of his business partners, Buffett considers a friend. “With the Heinz purchase, moreover,” Buffett said in his shareholder letter, “we created a partnership template that may be used by Berkshire in future acquisitions of size.”
Second, through its utility subsidiary MidAmerican Energy, Berkshire purchased NV Energy, a public electric utility company in southern Nevada that services the Las Vegas Valley. NV Energy supplies electricity to “about 88 percent of Nevada’s population,” according to Buffett, which makes the business effectively inseparable from the economy of the region. As long as Nevada consumes power, NV Energy will be there to supply it. Buffett emphasized that “NV Energy will not be MidAmerican’s last major purchase.”
But purchases like this naturally fall outside the realm of possibility for most investors, so again we’ll turn to the world of ETFs. One to check out is the WisdomTree Earnings 500 Fund (NYSEARCA:EPS). If you can’t tell by the ticker, this fund stacks itself based on the earnings power of the 500 largest companies sorted by earnings.
3. Short-term government bonds
Equities tend to offer better returns than bonds, but they also require a higher risk tolerance. Most portfolios are incomplete without some bonds, and Buffett recommends those at the shorter end of the duration spectrum.
Bonds have been a tricky investment recently thanks to loose monetary policy and quantitative easing — for example, PIMCO’s Total Return Fund, the largest and one of the most successful bond funds in the world, posted its worst year since 1994 in 2013 — but sticking to the shorter end of the duration spectrum can provide some shelter against interest rate fluctuations as the Federal Reserves executes the taper.
Vanguard offers a short-term bond etf (NYSEARCA:BSV) that fits the bill and carries an expense ratio of just 0.10 percent.