VR Logo

Unexpected lessons from Buffett's Bet

Warren Buffett's ten year bet proves what it was expected, but there's a surprise too

Unexpected lessons from Buffett's Bet

When the world's most successful investor says that we (and I mean all of us) may be making a terrible mistake, we need to pay attention. Here's what Warren Buffett says in his letter to shareholders for 2017, which was released last week, "It is a terrible mistake for investors with long term horizons - among them, pension funds, college endowments and savings minded individuals - to measure their investment 'risk' by their portfolio's ratio of bonds to stocks". Buffett's point is simple, that in the long run, bonds--and by implication other fixed income investments--are actually riskier than stocks. The background of why he says so in this letter is a fascinating story by itself.

In December 2007, Warren Buffett made a bet that over the next ten years, a portfolio consisting of hedge funds would not be able to beat the S&P 500 index. Buffett's goal was to, "publicize my conviction that my pick - a virtually cost free investment in an unmanaged S&P 500 index fund - would, over time, deliver better results than those achieved by most investment professionals...".

Investment Advisor Protege Partners, Buffett's counterparty to the bet, picked five funds of funds that it expected to overperform the S&P 500. Those five funds of funds in turn operated portfolios that had investments in more than 200 hedge funds. At the end of that period, in December 2017, the five funds of funds ended up with a gain of 36.3 per cent, while the S&P500 based investment earned 125.8 per cent. The five funds' returns ranged from 2.8 per cent to 87 per cent. So as expected, the hedge funds massively underperformed the index.

However, the 'terrible mistake' that Buffett referred to came from another aspect of the bet. The bet was for a million dollars, with half the amount coming from the two players. The agreement was that at the end of the decade, a million dollars would be donated to a charity chosen by the winner. To pay out the million dollars, each of them (Buffett and Protege Partners) bought the US government's zero coupon bonds for 318,250 dollars each, a sum that would grow to 500,000 dollars each in a decade. The bonds delivered 4.56 per cent to maturity from the price they were purchased for.

By 2012, the bond market was in such a state that the yield of these bonds was just 0.88 per cent. Although they would have reached a million dollars as projected, they had already made most of that target. Buffett and Protege Partners decided that any investment in stocks would do better. As Buffett points out in the letter, even the dividend yield of the S&P500 at that point was 2.2 per cent, almost three times that of the earnings that the bonds would have yielded. So they agreed to sell the bonds and invest the proceeds in the stock of Buffett's own Berkshire Hathaway.

The result of this switch from bonds and stocks was amazing. After five more years passed, when the bet ended, Buffett's chosen charity ended up getting 2.2 million dollars. In the bond investment, it would have got one million dollars.

This is what Buffett says: Investing is an activity in which consumption today is foregone in an attempt to allow greater consumption at a later date. 'Risk' is the possibility that this objective won't be attained. By that standard, purportedly 'risk-free' long-term bonds in 2012 were a far riskier investment than a long term investment in common stocks. At that time, even a 1 per cent annual rate of inflation between 2012 and 2017 would have decreased the purchasing power of the government bond. ... in any upcoming day, week or even year, stocks will be riskier - far riskier... As an investor's investment horizon lengthens, however, a diversified portfolio of U.S. equities becomes progressively less risky than bonds, assuming that the stocks are purchased at a sensible multiple of earnings relative to then-prevailing interest rates.

Buffett is talking about the US but this is just as true in India. Apart from that the statement stands by itself. Any investor ignores this truth at his own peril.