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Warren Buffett just said bonds are “a really dumb” investment – here’s why

Warren Buffett just said bonds are “a really dumb” investment – here’s why

Most financial experts, investment advisors or money managers you talk to like to talk about the different kinds of investment vehicles out there – stocks, bonds, currencies, and so on – in terms of how much those assets are likely to change in price. They also like to frame the extent of that variability as risk, because it makes it easier to understand some of the differences between each asset. The interesting thing is that based on Berkshire Hathaway’s most recent annual report, the Oracle of Omaha doesn’t agree. Warren Buffett even goes so far as to call bonds “a really dumb” investment.

Buffett’s Bet

Buffett’s conclusion really has its roots in a bet he made in 2007 with a well-known hedge fund manager that simple, low-cost investing in the S&P 500 index, over a ten-year period, would beat even a team of the best of the best hedge fund managers around. The stakes for the bet were a $1 million combined donation to a charitable organization of Buffett’s choosing. Mr. Buffett and his counterpart each secured that final stake at the beginning of the bet by purchasing zero-coupon ten-year Treasury bonds. They each bought $500,000 worth of these bonds for about $.60 on the dollar; at maturity the bonds would be redeemed at their face value of $500,000 each and the donation would be made.

Zero-coupon bonds (also called STRIPS) carry no annual yield; the entire return possible in the bond is the difference between where it was purchased and its face value at maturity. The roughly 40% net return offered over a ten-year period at the time, then offered an annualized return of about 4% return. Treasury bonds are generally considered among the safest of debt instruments since they are backed by the full faith and credit of the U.S. government. That meant that no matter who actually won the bet, the $1 million charitable donation was guaranteed.

As recounted by Buffett, in 2012, and five years into the bet, because of the variability of bond prices, their zero coupon bonds had actually increased in value to about $.95 on the dollar. If you factor that $.45 increase over five years, that means those bonds had actually returned about 9% on an annualized basis, which by itself really isn’t too bad. At that point, however, Buffett and his counterpart had an interesting dilemma: continuing to hold the bonds for the five years that remained in the bet meant that there would only be about $.05 total return possible from that point. That was only 1% per year. They decided they could probably do better by selling the bonds at the market rate and reinvesting the proceeds in the stock market – specifically by buying shares of Berkshire Hathaway Class B common stock. The combined total purchase of those shares, then was about $950,000. The logic Buffett and his counterpart followed to justify the move was that even if the market didn’t perform well, the value of Berkshire’s earnings was practically certain to average about 8% per year. That’s pretty easy math, isn’t it – 8%, or 1% per year?

Fast forward now to 2017 and the end of the bet. The total donation Buffett and his counterpart ended up making to his charity of choice totaled more than $2.2 million – far in excess of the $1 million originally guaranteed by the high-safety, zero-coupon bonds they started with. That means that over the final five years, their Berkshire shares netted them a total of about $1.25 million – an annualized return of more than 26% per year. Buffett finished recounting the story of his bet by concluding, “often, high-grade bonds in an investment portfolio increase its risk.”

Bonds and Risk

This is very different than the thinking espoused by financial advisors and planners, who almost always like to talk to clients about using a mix of stocks, bonds, and cash to lower risk. If you tend to be more risk-averse, they’ll usually recommend increasing the percentage of your money in bonds, while at the same decreasing your exposure to stocks. The logic sounds reasonable; since bonds generally don’t fluctuate in price as much as stocks, your money is safer in those instruments. So what could Mr. Buffett mean when he says that even high-grade bonds could increase your risk?

The answer lies back in the story of the zero-coupon bonds he and his counterpart used. Remember that zero-coupon bonds have an absolute ceiling that they can’t rise above; they will never increase in value above $1 for every $1 invested (also called par value). Even though the fluctuations of the bond market can push the value of those bonds closer to par value, their fixed value at maturity, combined with the fact they include absolutely no annual interest means they will never exceed that fixed level. That means that in 2012, when those bonds were worth a little more than $.95 on the dollar, the roughly 1% annualized return that remained was the entire sum of what could be expected from that investment over the next five years.

What is investing? It’s pretty simple, when all is said and done: it means setting money, and the purchasing power it offers today, aside for the prospect of greater purchasing power at some point down the road. One of the elements every investment has working against it is inflation – the increase in the cost of purchasing goods and services over any given time. The objective, ultimately of any investment is to increase the value of your money at a faster rate than the pace of inflation over a measurable rate of time.

Now think about that roughly 1% annual yield that was left in those zero-coupon bonds for the next five years. If inflation increased more than 1% in any year, the purchasing power of the money in those bonds would actually decrease. That’s risk, and that’s why Buffett and his counterpart decided to make the shift into Berkshire stock. That is why even the “safest”, high-grade bonds offer more risk than people really think about.

Opportunity Risk

Another element of risk is what I like to think of as opportunity risk, and while Buffett doesn’t address it directly, his story is still illustrative of the point. Keeping their money in their zero-coupon bonds would have resulted in an absolute, fixed, and pre-determined result at maturity in 2017. Critics of investing in more volatile assets like stocks will say that the zero-coupon bonds offered greater peace of mind, even if they don’t keep pace with inflation, because you know going in what you’re going to end up with. What you have to give up for that “peace of mind” is where I think the real risk lies.

It’s true that in any given short-term period, ranging from a few days to a year, investing in stocks is inherently more volatile and, yes, riskier than dealing with less volatile assets, including bonds. That risk becomes more and more limited over time, however, and when you start looking at long-term time periods it actually inverts, where the real risk lies in continuing to focus on “safer” assets. Let’s think about the value of money over the last ten years, factoring inflation into the equation, and whether you invested $1,000 in the stock market or kept it in a “safe” investment offering a fixed, 1% annual return such as the zero coupon bond used in Buffett’s bet.

Playing it safe would have meant that the $1,000 you started with in 2007 would have actually been worth less – by almost 6% – in 2017. And while 2008 would have been a rough way to start, sticking with the stock market would have meant almost doubling your money after ten years of time. To borrow a term from Mr. Buffett, friends, that’s “kindergarten” math.

Looking at current market conditions, and well into year 9 of a very extended bullish market, it’s true that over the short-term, volatility in the market could translate to negative movement in stock prices. That’s why it’s important to think about what your investment objectives are, and even more importantly, to consider what your real time horizon is. If you really want to be able to grow your money over any long-term time period – five years or more – the highest-probability way to really do it is with a smart, sensible investing approach using stocks.

Approach with care – be smart

A word of caution is warranted anytime you’re thinking about investing in the stock market, simply because it is true that over short periods of time, stock prices can be very volatile. It is also important to keep in mind that the market ebbs and flows from high to low and back again, just as the economy swings from healthy and robust to weak and stagnant. That means that the longer a bullish market lasts, the greater the chance is that it could reverse to the downside. The -37% performance in the S&P 500 shown in the table above for 2008 followed a practically uninterrupted five-year run of positive annual returns in the stock market. Now nine years into today’s bullish market, we’ve beaten the previous market’s run in truly impressive fashion; but it also means that the market could be even more ripe for a downturn than it was eleven years ago.

The truth is that if you invested $1,000 in the S&P 500 in the stock market in 2008, only to watch it decline in value by nearly 40%, you would probably do like just about anybody else: you’d take your money out of the money and never want to look back! Very few people have the courage to sit through that kind of slide, saying simply that they “need to be patient” and let the market run its course. So what do you do if you want to start investing? Let’s take another page from the Book of Buffett.

Berkshire’s annual report shows that the company is currently holding more than $110 billion in cash and liquid assets, and some estimates put the number at closer to $116 billion. Historically, Buffett prefers to keep about $20 billion in available cash at all times, which means that he is currently sitting on more than five times his normal cash levels. Why? It isn’t because Buffett is hesitant about making deals to make new acquisitions, but rather because he is careful about when he makes a deal. As perhaps the most famous value investor in the entire world today, Buffett is oftentimes referred to as “a Walmart shopper” when it comes to buying stocks or companies. And with the market at or near all-time highs, the truth is that the kind of great valuations he prefers to work with are just hard to find.

Under current market conditions, the smart approach to the stock market follows very much in the same vein as Mr. Buffett’s natural inclination: be willing to make a purchase if you think there is a great opportunity to be had in the long-term, and don’t be afraid to let the stock’s price experience short-term volatility and high variability. Be cautious and selective about how often you buy, and how much of any stock you do buy. With the market as high as it is right now, holding onto more cash than normal right now means that when you do find the kind of opportunities that give you great long-term odds of success, you’ll have the financial flexibility and capacity to take advantage of them at the right time.

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