The education of any business person is incomplete if it doesn’t include a thorough reading of Warren Buffett’s annual letters to shareholders. I often say that I have learned more from reading his annual letters than I have reading anything else. And I spend much of my days reading! That said, this year’s letter was no different than usual. In fact, it was even more jam packed than normal because Buffett spends more and more time these days focusing on Berkshire AFTER Buffett. So his life lessons are more widely discussed than ever.You should go read the letter yourself, but in case you don’t have the time I’ve jotted down some of the key takeaways:
Macro Matters. As much as Buffett focuses on the micro (specific companies) he’s always mindful of the macro. And he certainly understands that his success couldn’t have happened without riding the biggest macro wave of the last 100 years – the amazing growth of the US economy:
“Who has ever benefited during the past 238 years by betting against America? If you compare our country’s present condition to that existing in 1776, you have to rub your eyes in wonder. In my lifetime alone, real per-capita US output has sextupled. My parents could not have dreamed in 1930 of the world their son would see.”
As I always say, it’s easy to look like a great swimmer if you can figure out the direction of the current. Figure out the macro and the micro more easily falls in place.
Accounting, accounting, accounting. If you read a Buffett letter you’ll notice that it’s filled with accounting tables. I’ve stated in the past that the language of economics is accounting. It is the way we communicate the health of our economy, our institutions and our people. Buffett knows this. Buffett’s a masterful businessman because he understands the language of economics. If you’re not well versed in accounting do yourself a favor and spend more time learning the language of economics – accounting.
Stocks are tremendously good assets for protecting your purchasing power. I think of portfolio construction as serving two primary goals – protecting against the risk of permanent loss and protecting against the risk of purchasing power loss. This is a concept I’ve called the “Total Portfolio Approach”. While many investors think of “real” commodities as the best way to protect against inflation it’s actually better to think of stocks as a protector of purchasing power. Buffett says:
“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, which, with reinvested dividends, generated the overall return of 11,196% shown on page 2. Concurrently, the purchasing power of the dollar declined a staggering 87%. That decrease means that it now takes $1 to buy what could be bought for 13¢ 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 fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities – Treasuries, for example – whose values have 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. “
Yes! Think of equity as a claim on underlying output. If that claim is a contractual obligation tied directly to the profitability of productive firms then we can and should expect the real value of those claims to rise over long periods of time because they are essentially a form of currency issued directly by corporations themselves. And if output is what gives our currency real value in the first place then we should expect a diversified portfolio of claims on output to grow in real terms over time. Stocks are the ideal way to gain access to purchasing power protection.
Risk is not volatility. Buffett understands the limits of textbook models of the world. One of the more dangerous concepts in modern finance is the idea that risk is synonymous with volatility. As Buffett notes:
“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.”
Risk is the potential that we won’t meet our financial goals. And for most investors that means protecting against purchasing power loss and the risk of permanent loss. Focusing on risk as volatility often leads investors into an unbalanced perspective where why they actually believe they can take far more risk than is appropriate simply because stocks tend to be skewed towards positive returns over the long-term. But this totally ignores the fact that most investors also desire balance between generating high returns and creating stability in their savings. Misunderstanding risk is often the biggest mistake we make in the process of portfolio construction.
Stop paying high fees. Buffett rightly calls out the high fees that are often so unfriendly to investors. I’ve noted on several occasions how much a 1% recurring fee will hurt total returns over the long-term. But we can do even better than that. A smart portfolio can be built with a fee structure that is well below 1%. Chasing returns in exchange for high fees is what Buffett calls a “fool’s game”:
“The commission of the investment sins listed above is not limited to “the little guy.” Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades. A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game.”
Collies are the best dogs. As the proud owner of a Border Collie/Aussie Shepherd mix, I can appreciate Buffett’s comment on collies:
“Charlie and I frequently get approached about acquisitions that don’t come close to meeting our tests: We’ve found that if you advertise an interest in buying collies, a lot of people will call hoping to sell you their cocker spaniels.”
Buffett has stated in the past that he prefers to surround himself with people who are smarter than himself. This is as true with people as it is with dogs. My collie is one of the many women I live with who regularly outsmarts me, but more importantly, teaches me consistently on how best to live my life.
We are our biggest enemy. The biggest mistakes we make in the investment world are often due to the fact that we try to make too many decisions. We are prone to mistakes because we are prone to be biased. When you understand your flaws you can prepare your portfolio against its biggest enemy – ourselves:
Decades ago, Ben Graham pinpointed the blame for investment failure, using a quote from Shakespeare: “The fault, dear Brutus, is not in our stars, but in ourselves.”
Learn from your mistakes and never stop learning. This year’s letter was filled with life lessons. I always say that we can never stop learning in this world. And the best lessons often come from understanding our mistakes. A mistake is only a mistake if you don’t learn from it. Never stop learning. And never be afraid to make mistakes so long as they turn into good lessons.