Archives for May 2017

Instead of watching the entire 6-hour Berkshire Hathaway (BRK) annual shareholder’s meeting, I first read through the WSJ highlights and then watched selected parts of the Yahoo Finance replay which interested me.

One interesting topic was about Warren Buffett and Charlie Munger’s directions to their heirs. Buffett has famously directed his wife to put 90% of her assets into a Vanguard S&P 500 index fund and 10% into US Treasuries. In contrast, Munger has told his family “not be so dumb as to sell” their Berkshire stock. Why do they differ?

You can see this question at the 1:39:55 marker in the video. Here are my notes:

• Buffett initially tries to deflect this question by stating that 100% of his BRK stock will be given to charity. However, there would be nothing stopping her from buying BRK shares (or any other investment) at a later time, so that doesn’t really answer the question.
• Both Buffett and Munger have previously stated that they believe that Berkshire will likely perform better than the S&P 500 in the future.
• Buffett’s wife will have more money than she needs. Maximizing upside is not important. Downside protection is most important.
• In terms of investment performance, both are quite unlikely to suffer permanent loss, but the S&P 500 is still a little bit more reliable than BRK. There is still some chance that there could be a change in culture or executive leadership that might damage the company. Someone might succeed in breaking up Berkshire into parts.
• The 10% in short-term US Treasuries (essentially cash) goes even further, in case there is long severe depression or even if the stock exchange is closed, there will be cash on hand to handle things.
• In terms of human issues, it would be a news event if she had BRK shares and sold them. The media would care. Talking heads would offer alternatives. However, if she holds the S&P 500 index fund, that is so boring that it is quite likely nobody will ever bother her again. From all that I have read, never being bothered again sounds like something she would enjoy. (Most people don’t even know her name or what she looks like.)
• Munger concedes that the S&P 500 as well-constructed as a diversified portfolio of large companies. In terms of performance, it is “all but impossible for most people [to beat].” However, he’s still telling his family to stick with Berkshire.

Buffett and Munger are exceptionally rational as opposed to emotional. Therefore, both answers will most likely work out fine. Sometime in the next 50 years, the stock market will probably drop 50% again. The fact that Buffett thinks the S&P 500 is safer than even Berkshire is something to remember the next time there is a stock market crisis.

At the same time, Munger’s comments should make a current BRK shareholder feel more secure in holding shares for decades to come. Even with Buffett’s shares going to charity, there will still be a large chunk of shareholders with a long-term view.

A reader asked me to expand on the thought process behind my asset allocation choices. I don’t have a highly scientific answer, but here’s how I would explain it to a friend over drinks. Prepare yourself for some rambling…

I know that I could run simulations and backtest return data to figure out exactly which mix of assets have produced the best risk/return characteristics historically. I’ve also looked at various model portfolios based on such analyses. However, perfection can only be seen in retrospect and it is constantly changing. I just try to take away the big nuggets.

The overall goal is to hold asset classes that will provide long-term returns above inflation, distribute income via dividends and interest, and finally offer some historical tendencies to balance each other out.

Stocks Breakdown (Benchmark Ticker)

• 38% US Total Market (VTI)
• 7% US Small-Cap Value (VBR)
• 38% International Total Market (VXUS)
• 7% Emerging Markets (VWO)
• 10% US Real Estate (VNQ)

To put it briefly, I am taking the total markets and increasing the portion of one additional asset class which I think has the highest diversification benefits. For example, Small Value is a subset of Total US market, and Emerging Markets is a subset of the Total International market.

38% US Total Market. Instead of “stocks” or “equities”, I prefer to call it “owning businesses”. It’s not just a ticker blip going up and down. I am buying a diversified mix of real businesses that are a critical part of a huge economy. A single company or even a handful of big companies might go bankrupt, but as a whole they are not going anywhere.

The Vanguard Total Stock Market ETF (VTI) holds 3,600 stocks to represent the entire US publicly-listed market from Apple ($770,000 million) to Bridgford Foods Corp. ($100 million). It is market-cap weighted, which means that the amount of each stock held is directly proportional to the total market value of the company. See my VTI review for details.

7% US Small-Cap Value. Historically, small-cap value stocks have produced a higher risk-adjusted return than the entire market. You could also argue that small companies a more representative of the private business market. Therefore, I choose to hold a little more of this asset class via the Vanguard Small-Cap Value ETF (VBR).

You probably haven’t heard of 99% of the stocks in the Small Value index, which is kind of the point. Someone who invests in individual small cap stocks must be wary of that company going bankrupt (or effectively bankrupt). But by owning 828 of these stocks at the same time, I don’t have to worry about VBR ever going to zero (although it can be relatively volatile). Will VBR outperform VTI by a huge margin? Maybe, maybe not, but it probably won’t lag the overall market greatly either.

VTI can be roughly broken down into 85% Large-Cap companies, 10% Mid-Cap companies, and 5% Small-Cap companies. My blend of 85% VTI and 15% VBR is still roughly 72% Large-Cap and 19% Small-Cap. I have “tilted” the amounts, but it’s still predominantly composed of huge businesses like ExxonMobil, Google, and Johnson & Johnson.

International Total Market. The United States is not the only place where businesses create value. Many brands that you deal with every day are listed in foreign countries – Nestle, Shell, Samsung, Toyota, GlaxoSmithKline, Anheuser-Busch InBev. (Bud Light is a foreign company!) The Vanguard Total International Stock ETF (VXUS) holds over 6,000 stocks from around the world according to market-cap weight. See my VXUS review for details.

I also keep to close to the world market-cap split with 50/50 US/non-US. If you want to go 70/30 or 60/40, that’s perfectly fine with me. Again it’s more important that you stick with it than any specific ratio.

Emerging Markets. Within the foreign markets, I choose to put extra money towards Emerging Markets – countries that currently include China, Taiwan, India, Brazil, South Africa, Mexico, Russia, Thailand, and Malaysia. Again, this asset class is more volatile but also has higher historical returns. The Vanguard FTSE Emerging Markets ETF (VWO) allows me to track this asset class in an efficient and low-cost manner. If there were better options for International Small Value stocks, I would have been open to that.

VXUS is 43% Developed Europe, 30% Developed Pacific, 19% Emerging Markets, and 7% Canada. My blend of 85% VXUS and 15% VWO is 37% Developed Europe, 26% Developed Asia, 31% Emerging Markets, and 6% Canada. Again, it’s not a huge tilt.

(Exit option: If something happened to me and my wife wanted to simultaneously simplify the portfolio, reduce the overall risk level, and generate cash, she could simply sell off my US Small Value and Emerging Markets positions that make up ~10% of the entire portfolio. The resulting portfolio would still be diversified.)

Real Estate. The Vanguard REIT ETF (VNQ) holds publicly-traded real estate investment trusts (REITs) which hold things like office buildings, hotels, apartment complexes, nursing homes, self-storage units, and shopping malls. I choose not to be active in residential real estate other than owning my own home, so I like the diversification and income that this asset class provides.

I am sticking with domestic REITs for both simplicity and lower costs. REITS only make up about 7% of my overall portfolio. I might include foreign REITS if it was a larger holding, but I’m going to bother splitting up 7%.

Bonds Breakdown

• 50% High-quality, Intermediate-Term Bonds
• 50% US Treasury Inflation-Protected Bonds

I keep roughly 30% of my portfolio in bonds. This is meant to be the stable ballast of my portfolio, but it should also generate some level of interest income. Bonds are debt, so I only lend money to the places that I think will pay me back most reliably:

• US government, which can both tax residents and print the world’s reserve currency. This includes US Treasuries, FDIC-insured bank accounts, and US Savings bonds. Treasury Inflation-Protected bonds also offer an interest rate that adjusts with inflation.
• Local municipalities, which can tax residents. If you don’t pay your property taxes, they take your house. “Muni bonds” currently offer the best tax-effective yield for my situation. I hold them through low-cost, actively-managed funds like Vanguard Intermediate-Term Tax-Exempt Fund Investor Shares (VWITX). See, I’m not only about index funds!

I exclude investment-grade corporate bonds because I don’t see enough benefit in taking on extra risk in this manner. I’d rather get 3% dividend yield through stock ownership (which includes unlimited upside potential) than get paid 3% interest (with no upside potential). Corporate bonds don’t have the company interests aligned with you – they want to appear stable and pay as little interest as possible. I’m not overly trusting of bond rating agencies in general.

I also exclude international bonds because what’s the point of diversifying to get a significantly lower interest rate? Vanguard US Total US Bond Market ETF (BND) has a current SEC yield of 2.43%. Vanguard Total International Bond ETF (BNDX) has a current SEC yield of 0.74%. Blech!

Recap. At a basic level, I own baskets of US businesses, international businesses, real estate, and high-quality debt. I plan to eventually spend the dividends from the businesses, rent from the real estate, and interest from the loans. I expect the stock dividends and rent to increase faster than inflation. I expect that the bond interest will at least keep up with inflation. This mix makes sense to me and I believe I can hold it through the ups and downs. It is not perfect but it is good enough.