Warren Buffett’s Warning: Avoid This ‘Terrible Investing Mistake
I’d like to make this blog as digestible and easy-to-understand as possible. For any jargon included, indicated in italics, I explain the meaning in simple terms at the bottom of the blog.
It’s concerning to see young professionals in their 20s, 30s, and 40s investing the majority of their portfolios in bonds. It's like hearing someone has been keeping all their savings in an interest-bearing account. This behavior is surprisingly common.
Warren Buffet warned of a “terrible mistake” of not taking on equity risk as a long-term investor. “As an investor's investment horizon lengthens, a diversified portfolio of U.S. equities becomes progressively less risky than bonds”, he said. In 2014, Buffett said he plans to put 90% of the money he leaves to his wife, Astrid, when he dies, into an S&P 500 index fund, and 10% in government bonds. This is coming from someone who can afford the smartest financial advisers and asset managers in the world.
Charley Ellis, the former Chair of Yale’s Investment Committee, also highlighted this issue in a Financial Times opinion piece recently. He writes that the conventional 60:40 stock-to-bond portfolio split is outdated and will mean people will have less at retirement than they would like to. He also points out that we often overlook two crucial components when determining asset allocation: the equity portion of our homes and future social security benefits or employer pensions. Ignoring these factors can leave investors overly exposed to low-risk, low-reward assets, reducing our potential for investment growth.
To explain the difference between bond and equity/stock investments simply, I created this YouTube video. Investors I talk to who invest in fixed-income products do so for one reason: They know exactly what to expect. And this is the main reason they don’t want to put their money at risk in the stock market - because it means losing their sense of security. There are exceptions where a savings account “investment” would make sense - I discuss this later.
I’m hoping this blog will provide you with more information to understand the “equity risk” better, but more importantly, empower you to use this risk to your advantage to build wealth.
First concept: Stocks vs Bonds
Investing in bonds is like lending money to a business and agreeing to receive a fixed % of interest in return. Every month, or year, you know exactly how much interest you will receive, and at maturity of the loan you will receive your capital (original loan amount) back. There is a small risk the business goes under or cannot afford to pay you your interest, but this is a relatively low risk. The reward you receive is also low - as I will illustrate below - because the risk is low. This concept is similar to “investing” via a savings account where you earn a fixed interest rate.
On the other side of the risk spectrum, you could also buy shares in a business rather than lend the money. In this instance, your return can’t be “guaranteed” because it depends on 2 things: The profits of the company which they distribute to you as dividends, and the value of your shares - whether this is higher or lower than what you paid for it. As you can imagine a business's profits is dependent on so many things: the economy in which it operates, management of the business, competitors, products, changes in technology, supplier influences (costs, quality) etc. This is where volatility comes in.
Volatility
When people see a chart like this (below) showing stock market returns they get scared. Because there is so much “volatility”. Bonds, on the other side - the orange line - have much less volatility (up and down swings) and that’s why it feels like a safe investment. This chart shows the monthly returns of an S&P500 ETF for 21 years versus the monthly returns for a US Bonds ETF:
But there is one chart that scares me more than the chart above, it’s the chart below showing what $10’000 invested 20 years ago in the S&P500 has achieved compared to $10’000 invested in US Bonds. This extrapolates these “volatile” returns shown above to actual numbers to see the impact if you were invested over this time - it also helps to see the “bigger picture”.
For me, the scary part is not the 65% drop during the 2008 Global Financial Crisis, but rather the $60’000 gap between having invested in bonds and not in stocks. And this is exactly why Warren Buffet calls this a “terrible mistake”.
And if my earlier example of buying shares in a single business scares you off. Don’t worry - this is not what you have to do. You can, and should, diversify - and invest in hundreds or thousands of companies - at once. This way you don’t have to worry about selecting the right one or worry about the profits, dividends, or movements in stock prices of any one single company. The way to do this is by investing in index funds - or index tracker ETFs. Read my article Investing 101: Getting started if you want to get started.
When is it ok to invest in bonds or a savings account?
There are 2 exceptional scenarios where bonds or savings account investments would make sense:
When you expect to withdraw the investments in the short term. For example, money saved up for your emergency fund or for a holiday. In this case you would rather not take on the risk in the short term because withdrawing the money in a downturn could mean realizing losses and not giving your investment the chance to recover like it evidently does in the long term. If you want to know how much money to hold in a savings account - read my blog on 10 Healthy Money Habits.
Investing in bonds is the “low-risk” portion of your investment portfolio. The younger you are the less you should allocate to “low-risk” investments to make sure you give your money the best chance at long-term growth. A common rule you could use is holding a percentage of stocks that is equal to 100 minus your age. Therefore if you are 30 years old, 70% should be allocated to stocks and 30% to bonds. Personally, I don’t follow this guidance and I have 95% of my portfolio invested in stocks because I have a higher risk appetite.
Still not convinced?
I appreciate it can be nerve-wracking to take the risk and invest your hard-earned cash. But luckily we have years of data to show you how the market acts in the long term. Historic returns are not an indication of future returns but the stock market has recovered from the worst crashes and wars in history, and we could expect it to do so again in the future.
You should also consider that sometimes the interest you earn on savings hardly keeps up with inflation. If you hold soft currency, like the South African Rand, you should also take into consideration the annual depreciation of the Rand in the long term against global hard currencies. I wrote another blog explaining Why You Should Risk Your Money By Investing if you want to learn more.
Cutting through the jargon
Portfolios: A collection of investments, could include ETFs, Unit Trusts, bonds etc.
Equity risk: The risk, or volatility, you bear when you invest in equities, or stocks
Investment horizon: The time someone will be invested for, for example a 40-year professional who aims to retire at 65 has an investment horizon of 25 years.
Diversified portfolio: Holding investments from different
S&P500 index fund: An ETF that tracks the S&P500 index, which tracks the 500 largest listed companies in the US
Asset allocation: How investments are split between bonds and equities, or other investments such as properties.
Equity portion of their homes: The portion of your home that has been paid off. This is equal to the value of your home less the amount owed to the bank.
Fixed income products: A term used to describe an investment that yields a fixed return, like a savings account where you know exactly how much interest you will earn every month.
Volatility: Up and down movements in the stock market.
Stock market: A market where stocks are sold. This is where buyers and sellers of stocks meet, these days done fully digitally.
Disclaimer: This is not personalized financial or investment advice but rather for educational purposes. I have made every effort to ensure accuracy but it cannot be guaranteed. Do your own research before making investment decisions. Capital is at risk when investing.