Buffett Versus “Robo Advisors”

When we left off from our article about Warren Buffett and Indexing [see: https://www.markettamer.com/blog/what-twain-rothschild-buffett-and-bogle-said-about-risk-reward ]… I promised to create (just for you) a follow-up article that takes a long, lingering, reflective look at Buffett’s publicly announced Retirement Portfolio for his wife Astrid. This is the portfolio he outlined during this year’s Berkshire Hathaway (BRK.A) Annual Meeting on February 28^th.

Here is a refresher for you so we can pick back up where we left off: 

After prefacing his remarks by clarifying that, upon Buffet’s death, his personal BRK.A shares will be distributed to charitable institutions, Buffett offered this prospective “advice” to the trustee of his estate[7]:

“My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.[8]) I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.

“Both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So ignore the chatter, keep your costs minimal, and invest in stocks….”.

What is your first reaction to this “Widow” portfolio with the starkly simple asset allocation of 90% S&P 500 Index and 10% Short-term U.S. Treasury Securities? Is that an asset allocation that you would select for your grandparents, your parents, or yourself during the years following age 65? 

Within the context of the needs of a widow or retired person, what adjectives would you use to describe that portfolio:  

Diversified, Balanced and Risk Managed OR

Undiversified, Top-Heavy, and Risky

It is an understatement to observe that I will never enjoy the financial blessings or investment stature of Warren Buffett. That being said, it should not be a surprise to hear that every academic course I have ever taken on Investments, Asset Allocation, and/or Risk Management is predicated upon basic principles that run quite contrary to Buffett’s preferred plan above – particularly when his “plan” is designed for someone over age 65!

So let’s just say that Buffett’s 90%/10% Asset Allocation Plan is unconventional!

If any of you wonder why/how Buffett’s model portfolio is unconventional, I refer you to the middle of my recent article on Robo-Advisors [found at https://www.markettamer.com/blog/disruptive-technology-investment-management ]. The central premise behind Asset Allocation Strategy is that, for the financial need and risk tolerance of each investor there is an optimum portfolio (actually, a range of asset allocation options) that holds the potential to deliver the maximum return possible for the level of risk that investor is willing to tolerate.  That premise is illustrated in this standard graph, within which the X Axis represents “Risk” and the Y Axis represents “Return”: 

If one’s portfolio is top heavy with equity securities, the potential return in any year similar to 2013 will fall into the upper right quadrant of this graph – with a great return but also a commensurately high risk.  If as an alternative, one added at least two or three other asset classes into the portfolio, the aggregate return during a year similar to 2013 from that portfolio would likely be lower… but the portfolio’s risk would be significantly reduced as well! 

So the objective of an Asset Allocation Optimization Strategy is to formulate potential allocation plans that we can reasonably assume will deliver (over time) returns within the range we need for the risk we are willing (able) to tolerate.[1]  As a general rule, a portfolio with five or six assets classes will deliver a more consistent return with a lower risk than a one or two asset class portfolio (such as Buffett’s). One of the chief functions of a financial advisor is to guide clients toward an Asset Allocation Plan that will be congruent with the client’s risk tolerance and investment return needs.

As we have noted in earlier articles, one of the hottest trends within the financial world is the emergence of “Digital Wealth Management” (aka Robo-Advisors) –

who have automated Asset Allocation Optimization and therefore offer low cost portfolio management with very low minimum initial investment requirements! [See: https://www.markettamer.com/blog/could-hal-be-your-new-financial-advisor ; https://www.markettamer.com/blog/disruptive-technology-investment-management ].  Therefore, as I reflected upon Buffett’s 90%/10% portfolio, I began to wonder if “Digital Wealth Management” portfolios could out-perform Buffett’s portfolio! 

So, friends, sit back, kick your feet up, and let me run you through some projections… based on these assumptions:

1) Since this portfolio is intended to provide for Buffett’s widow, we will use her information as the basis for our data input, as requested by the Digital Wealth provider.

        a) Buffett married Astrid Menks on 3/14/2012.

         b) On the wedding day, she was 60 years of age.

                  i) I have therefore arbitrarily assumed a birth date of 3/14/1952.

c) Based on current actuarial tables, Astrid’s life expectancy would be 87.4 years… taking her to approximately June of 2039 (25 more years).

2) Please note the obvious – I cannot calculate portfolio value changes prospectively. Therefore, even though I am using Astrid’s current age as the baseline for creating our test portfolios… we are using market performance data that encompasses the past seven (plus) years.

a) I have chose these parameters because 7 years is an adequate stretch through which to “test” a portfolio’s performance over time and

b) There were literally millions of folks who were scheduled to retire between 2007 and 2009 who were faced with portfolio decisions and circumstances precisely like the ones we will review below!

3) The Digital Wealth provider also requested estimates of annual income and the total size of the portfolio to be invested.

a) We can all assume that Mr. Buffett has more than amply provided for Astrid after his death.

b) However, to ensure that this study is relevant for a wider range of folks than the widow of an ultra wealthy corporate leader, I made these additional assumptions:

         i) $100,000 of annual income (beyond portfolio income)

         ii) $1,000,000 in assets to be managed.

4) As mentioned above, to “Stress Test” these alternative Asset Allocation models, I decided to initiate the portfolio as of 10/9/2007.

         a) Each portfolio was rebalanced on October 9^th during each year thereafter[2].

b) Beyond the “Rebalance” dates, I calculated portfolio valuation on each of these significant dates: 

i) March 9, 2009 – a big swing low following the heart of the “Financial Crisis”.

ii) October 3, 2011 – a major swing low following the August (2011) downgrade of U.S. Treasury Debt.  

iii) May 21, 2013 – the S&P 500 Index high prior to Ben Bernanke’s press conference that kicked off a “Taper Tantrum” (the markets reacted in panic following Bernanke use of the term “taper” in connection with monetary easing.

iv) June 24, 2013 – the S&P low following the “Taper Tantrum”.

5) We will assume that the widow beneficiary does not withdraw any funds during the period under review below.

6) The run-out date on these portfolio calculations is November 24, 2014.

It would be a waste of your time to detail how these calculations were created. Just trust me that it was an extremely time-consuming process involving lots of worksheets with painstaking calculations each step along the way tied to each ETF within each of the allocation models. [It was a lot like getting lost down a “rabbit hole”![3] ]

First, let’s cover Buffett’s portfolio. Note that I am using the iShares 1-3 Year Treasury Bond ETF as a surrogate for short-term U.S. Treasury Securities.

90%           SPY           SPDR S&P 500 ETF

10%           SHY          iShares 1-3 Year Treasury Bond

The highlights in the data above are these:

1) Starting value:  $1 million

2) A scary low in value on 3/9/09 – the portfolio lost (virtually) half its starting value!

3) The portfolio did not move back over “break even” until the last third of 2012.

In this final portion of the Buffett values, note these data points:

1) The portfolio lost about $62,400 during the month following Bernanke’s May 2013 press conference.

2) That May 2013 value was not recovered until October.

3) The 25 months that followed the October 2012 rebalancing saw the portfolio pick up over 33% in value.

Given the assumptions listed earlier and the performance data shown above, the average annual return on Buffett’s 90%/10% portfolio during these 7+ years would have been 7.04%[4].

 The question we each need to ask our self as we consider Buffett’s portfolio is this:

“Would I have been able to bear with losing 50% of my portfolio value during the first seventeen months following my initial investment?” 

No offense to any of you, my friends, but financial behaviorists have published countless studies that strongly suggest the great majority of us would have “baled” long before March of 2009. Those studies suggest as well that market fear was triggered so strongly between 2007 and 2009 that the average investor would be loath to buy equities again until the market rebound was well on its way.

Indeed, on a macro level, mutual fund and ETF funds flows during the 2007 – 12 period verify the very financial behavior reported in the published studies referred to above. Therefore, millions of folks “missed out” on much of the amazing investment return generated by a bull market (2009 to the present) so unusual that financial commentators continue to find ways in which “this market is unlike any other market we have ever seen.”

So, as impressive as Buffett’s portfolio (under the assumption of “buy and hold”) might be, I need for you to imagine what that performance would be if we had not been blessed by over five years of “lower left to upper right”!!   It definitely would have taken a lot longer to recover to “break even” after losing half its value; and it would not have received the “rocket boost” it received during the 25 months following October of 2012! 

Let’s move on to the first Digital Wealth Management providers (DWP) generated portfolio!  I considered referring by name to the two DWP providers whose websites I used to generate these portfolio configurations… but then I realized that using images from their respective websites and publicly reporting “back tested” performance data from those portfolios would quite likely lead to legal difficulties. Since I am someone who prefers to “manage risk” rather than “tempt risk”[5], I will refer to them as DWP #1 (Digital Wealth Provider #1) and DWP #2. You’ll need to take my word for it that the asset allocations I am using below have come from two of the top five Digital Wealth Management providers in the United States!

DWP #1 offers a user the option to modify client input data over an extensive range of demographic metrics, risk tolerances, and return expectations. For this “test case”, I settled upon a taxable portfolio allocation[6] that had a risk rating of “8” (out of “10”). I choose “8” because I decided that I needed a middle ground between Buffett’s risky 90%/10% portfolio and a portfolio that would be too conservative to provide for a widow’s needs over her remaining life expectancy of over 25 years.

Here is the allocation configuration of DWP #1: 

Here are the values calculated through October of 2012: 

1) Note that (as before) the starting value is $1 million.

2) The low point in this portfolio is a dismal $467,129 .. in March of 2009 (Yikes!).

3) As with Buffett’s portfolio, “break even” was not regained until the final third of 2012!

Here are the rest of the figures:

1) Note that the DWP #1 portfolio did push up in value during the 25 months that followed October of 2012… however, while Buffett’s portfolio zoomed upward by 33%, the DWP #1 value moved up by just over 12%!

a) Obviously, that can be accounted for by the more conservative (but well-balanced) allocation of       DWP #1!

2) Once again, on a “buy & hold” basis, this DWP #1 portfolio provided an average annual return of 5.58%. 

From DWP #2, I chose two different taxable account portfolio configurations (they actually offered three – Aggressive, Growth, Conservative):  

1) Aggressive: 

2) Conservative: 

There are some quick and obvious facts that jump out at us when we take a look at these Digital Wealth Management portfolio configurations:

1) Surely you noticed that five out of the nine ETFs chosen (in the aggregate) within these portfolios are from Vanguard Group!

2) This should not be surprising, since as we pointed out in an earlier article [ https://www.markettamer.com/blog/what-twain-rothschild-buffett-and-bogle-said-about-risk-reward ], Vanguard ETF’s and funds are known as among the least expensive in the industry… and they are large enough to provide good liquidity.[7]

3) There is absolutely no difficulty seeing, straight from the “get go”, the huge risk differential between the “Conservative” portfolio from DWP #2 and the other portfolios.

a) The 33% allocation to short-term Treasuries is highly unusual… but may well reflect the risk appetite of most U.S. investors between late 2008 and 2012!

b) You will soon see that a 33% allocation to SHY can have its advantages! 

What was the performance from the “Aggressive” portfolio suggested by DWP #2? 

 During these first months, we can see that this DPW #2 configuration dipped to the lowest value among all of these portfolios at the March 9^th (2009) market nadir! Also note that, unlike the two earlier portfolios, this portfolio did not crawl back above “break even” until after the October Rebalance in 2012!! 

During these final two years, note that DPW #2 Aggressive lost about 10% during the “Taper Tantrum”.  And similar to DPW #1, this portfolio could not regain its “pre-Taper” value until after the October Rebalance in 2013. During these 7-plus years, DPW #2 “Aggressive” offered an average annual return of 4.07%!

Finally, let’s take a look at the results from DPW #2 “Conservative”.  What results do you expect?  Do you think that this very conservative portfolio stands any chance at all in competing with the three prior portfolios (that are so stacked with equity-related ETFs)?

Well, friends, are you surprised? Note the following: 

1) The “low” value in this portfolio in March of 2009 was $822,907… down less than 18% from the initial investment date!

2) The portfolio moved back over “break even” by the Rebalance date in 2009!

3) It handled the downgrade of U.S. Treasury Debt much better than the other portfolios.

Also, see that this portfolio only swooned by 5.1% during the “Taper Tantrum”! During this 7+ year period, the “Conservative” portfolio offered an average annual return of 5.1%!  So whether we expected this or not, over the course of these 7+ years the “Conservative” portfolio out-performed the “Aggressive” portfolio!

What do the return curves look like for each portfolio?

 

 

And then, comparing them together in one graph, we have this:

INVESTOR TAKEAWAYS:

First, let me emphasize an essential truth that is more applicable within this setting than in many other settings within which you will read it or hear it read:

“Past performance is no guarantee of future results.”

Boy is THAT true!

As I already pointed out, the superiority of Buffett’s “Widow Portfolio” vis-à-vis the other three portfolios I have presented to you is by no means a superiority that will necessarily remain true during the next seven years! In fact, I fall within the growing camp that suspects that, at some point during the next 3-7 years, the investment world will need to “Pay the Piper” for the unprecedented monetary easing of Central Bankers around the globe.

It can not be emphasized enough that, currently, the world is literally “awash” in sovereign paper currency[8].

If I am correct (and heaven knows that I hope I am not) the expectation would be that Buffett’s equity-heavy portfolio would not perform as well as the “Conservative” portfolio.

Next, one of the very reasons that the Conservative portfolio lagged so far behind Buffett’s during the past 25-30 months (relatively speaking) is the U.S. Federal Reserve’s “ZIRP” (Zero Interest Rate Policy).

ZIRP has had the dual impact of pushing average P/E ratios upward (increasing prices) and keeping the level of interest earned from Treasury Bills (and bank C.D.’s, etc.) way down.  I have no empirical basis for suggesting this, but my hunch is that if Ben Bernanke had not introduced QE1, QE2, and QE3, the Conservative Portfolio would have at least kept pace with (if not outperformed) the other portfolios.

Third, it is instructive to notice something to which some of us might have become blinded during the past few years of double digit market gains:

The average investment return of all of the “Balanced” portfolios [by which I mean all the portfolios except Buffett’s] during these past 7 years is close to 5%.

That has become extremely significant within the financial planning community because advisors are cautioned to be very circumspect whenever she/he suggests possible prospective investment returns!  I clearly remember that during the 1990’s, the metric frequently bandied about as though it were some sort of “gospel” was this: “An equity investor could expect an average annual return (based on historical patterns) of 8-10%.” 

The day of such a routine (sometimes too casually mentioned) assumption is over!! Increasingly, professional advisor articles are being written (and fairly widely accepted) that a “new normal” for portfolio return assumptions needs to be acknowledged. Many experts have come to feel that an “assumed future return rate” that can responsibly be used within the design and presentation of a Retirement Plan” is approximately 4% per year.  That is a stark departure from industry benchmarks from just two decades ago! 

For those who enjoy irony, I have added an intriguing “Afterward” following this article’s “Disclosure” section. I virtually guarantee you will find it interesting and worthwhile… so please take a moment to look at it! 

Finally, my friends, as you consider the slope of the return graphs from these four portfolio configurations —  

particularly the slope between October of 2007 and March of 2009 – with which portfolio would YOU have been able to live comfortably, without nightmares of being left short of  sufficient assets to get you through the remaining years of your life? 

As I considered that question myself, I realized that during the heady days of 2007, I would have been drawn to the DRW #1 portfolio[9].  However, as my portfolio acted like a crashing plane through 2008 and into 2009, my emotions would have been driven into panic mood.[10] 

That brings us to the chief “teaching point” from the mini investment treatise Buffett incorporated within this year’s BRK.A shareholder letter: 

The average investor is driven too much by the human emotions of fear and greed, therefore making her/him vulnerable to the crafty wiles of those who would have them buying or selling too much of the wrong funds (or other securities), thereby running up investor trading costs[11] while not significantly improving portfolio Profit/Loss. All the studies I have read establish the fact that the investment record of the average investor invariably falls (considerably) short of the return provided by a mainline index (such as the S&P 500) over the long run because of the very factors identified by Buffett: fear and greed that lead to the high cost of overtrading, as well as counter-productive efforts to “time the market”.

DISCLOSURE: Nothing in this article is intended as a recommendation to buy or sell anything. Always consult with your financial advisor regarding changes in your portfolio – either subtractions or additions.

AFTERWARD:

During his shareholder meeting lesson directed toward the average investor, Buffett prefaced his remarks by reiterating a point he has regularly made through the years – neither he nor Charlie (Munger) ever recommend buying BRK.A [it would be self serving and neither of them is a Registered Investment Adviser]. 

The irony of that can be found in the performance metric tables below for BRK.A stock:

Note that the March 2009 low (as shown above) is considerably higher than the value on that date from all the other portfolios … except the “Conservative” option.

The “Taper Tantrum” only mildly buffeted the stock price between May and June of 2013. And most significantly, BRK.A ended up being valued at $1.75 million by November 2014 – representing an average annual investment return of 9.79% since the initial purchase in October of 2007!  That blows the 7.04% return from Buffett’s own 90%/10% portfolio out of the water! 

That said, I offer this final thought: 

         While I would never ever, ever, ever (read that as “never in a million years”) recommend that anyone have all their discretionary assets invested in the stock of one company, a widow (or anyone else) would have done better with BRK.A than with these other “indexed” portfolio choices. I think that is ironic, given that Buffett has been widely criticized during the past several years for failing to match his remarkable long-term investment record. I’d say that the data above confirms that the venerable and wizened Buffett has not “lost his touch” in any way.

         And consider that a portfolio to be invested for the benefit of Astrid following Buffett’s death might be well advised to invest in BRK.A a few months following the funeral!  Why?  Because I can assure you that the price of BRK.A stock will take a significant “hit” once Buffett is no longer around to lend the company and the stock his unique cache among finance and corporate chieftains around the world! If one assumes that the company Buffett built from scratch and has taken pains to structure for the long-term … including the hiring and training of exceptional investment managers… is indeed a solid conglomeration of companies that generate large amounts of annual cash flow and a reasonable long-term profit – it could be an incredible “bargain” within weeks following Buffett’s death!

FOOTNOTES:

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