Finance 201: What is the Warren Buffet 90-10 Portfolio?

Hi friends,

Has anyone not heard of Warren Buffett? Hahaha. He may be in one of my series in the possible future. But yes, some information about him first:


1. He was born in 1930, Omaha Nebraska (That's why he is also nicknamed as the Oracle of Omaha). 2. He is one of the most successful investors of all time, with a net worth of US$72B (corrected as of 4th May 2020).
3. He runs Berkshire Hathaway (BRK.A), a company with the highest stock price in the work (It is priced at US$273,975. This is already lower due to the Covid-19 situation.)
4. He became a millionaire at the age of 30 (I aim to have 1/10 of what he has by 30)
5. He became a billionaire at the age of 55 (I aim to be 1/500 of what he has by 50)

As you can see, he is really really really rich. In fact, he is the 4th richest person in the world. He is also a firm believer in value investing. According to him, there are companies in which the stock market would value lower than its intrinsic value (undervalued). Hence, he has invested in these companies that brought him to his fortune today.

Portfolio
Thus, I thought it would be interesting to figure out what he perceives to be a good retirement/long-term portfolio. The information is found in his 2013 letter to Berkshire Hathaway shareholders. In the instructions to his will, Buffett has instructed the trustee to invest 90% of his asset (the amount left over after donating a large portion to charity) into a low-cost S&P 500 index fund and invest the remaining 10% into short-term government bonds.

Reasoning:
He reasoned that the majority of high-fees managers underperform market indexes like the S&P 500 in the long run, hence, he believes that the portfolio returns held by this trust will be superior to those attained by most investors. The 10% allocation to bonds also acts as a hedge against stocks as when the S&P 500 goes down, government bonds would rise in value.

With that settled, let us take a look at the backtest of the performance of this portfolio, shall we? I will be splitting this into 3 portions, the long-term performance of this portfolio, performance during bull markets, and bear markets.

Some of the data were taken from other financial blogs as I am unable to find the long term data. But if we were to look at a specific bull and bear market, I am able to test for them. 

Portfolio 1 is the 90/10 Buffett Portfolio while Portfolio 2 is the 100% S&P 500 portfolio

Long term return:
From 1977 - 2019. We can see that the 90/10 portfolio does have a lower variance as compared to the 100% S&P 500 portfolio. But also, it has a noticeable lower return as well. 



Bear Market Performance (Mar 2000 - Oct 2002) and (Dec 2007 - June 2009) 



2000 - 2002


2007-2009



Bull Market Performance (Oct 2002 - Dec 2007) and (June 2009 - Jan 2020)


2002 - 2007 

2009 - 2020

From our observation, Buffett's portfolio has done better than the pure S&P 500 portfolio in a bear market, but worse in a bull market. Duh. Next better financial blogger, please. hahaha.

But what I want you to understand is that in a bear market, there is some significance in the CAGR and best year performance. In the GFC, CAGR of portfolio 1 was -21.42%, the best year was 3.12% CAGR of portfolio 2 was -24.16% and the best year was 3.21%. In the dotcom bust, portfolio 1's CAGR was -11.68%, the best year was -1.25%. Portfolio 2's CAGR was -13.89% and its best year was -2.38%. This would really show the impact that having some stocks would have on your portfolio. It can cushion a bit of your losses, while in an upmarket during a bear market period, it can perform just as well. 

So... two key points:
1. Minimise your losses
2. Perform almost as well in an upmarket in a bear market period. 

Meanwhile, the bull market scenario is quite in line with what we hold as conventional wisdom. So there isn't much to write about. 

Just one more fun fact before I end of this series. Someone did the 4% rule with a 90% stocks and 10% bond portfolio. They have discovered that only 2.38% failed in a 30 years retirement period. It performed almost as good as a 60% bond and 40% stocks portfolio. Hence, this is something that you might want to take note of.

While this portfolio may not allow you to be as rich as Warren Buffett, I hope that the lessons learned today will allow you to take better control of your personal finance. 

Till then,
Stay vested, stay frugal my friends. 

Dionysius




Sources
https://www.theoptimizingblog.com/warren-buffett-portfolio/
https://www.fool.com/investing/2019/11/26/an-in-depth-breakdown-of-warren-buffetts-portfolio.aspx
https://www.fool.com/investing/2019/09/08/warren-buffetts-investing-plan-for-his-family-why.aspx
https://www.investopedia.com/articles/personal-finance/121815/buffetts-9010-asset-allocation-sound.asp
https://www.financial-planning.com/news/testing-warren-buffetts-suggested-retirement-portfolio
https://www.gurufocus.com/news/824671/how-warren-buffett-made-his-first-million

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Finance 101: What is a Bond?

Hi friends, 

Bond, James Bond

Up to this point, I hope that you have benefitted from this series. I have also benefitted from the series as I learned about infographics design for this series and reinforced my financial knowledge as well. Do let me know if you have any ideas for Finance 101 or any other series that I can do. 

With that out of the way, let's look at the financial instrument that allows you to be a loan shark - Bonds. So, what is a bond? 

Definition:
A bond is a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments. - Investopedia

Bonds are debt instruments. When you buy a bond, you are lending money to the company or government institution issuing the bond for a fixed rate of return. -DBS

The keywords are:
1. Loan/debt
2. From company/government to investor
3. Fixed-rate of return

Essentially, you are lending a sum of money to a company or government, in which you will receive interests annually for the period and you will receive the sum of money that you lent at the end of the period. The entity that issued the bonds would use the money and invest in projects/infrastructures that they believe will have a better return compared to the interest they pay you. (i.e, I borrow $5,000 at 1% interest, to invest for a return of 8%. Profit for me 7%)

Furthermore, in the event where the entity is unable to pay its debt (default), bondholders have higher priority over stockholders over the liquidated asset of that company. When the company makes money, bondholders are also prioritised over stockholders in receiving the money. 

"That's great! Why does everyone not rush to bonds?" Good question, that's because historically, bonds have an average return of 5% but stocks have an average return of 10%. Furthermore, low risk doesn't mean no risk. There are cases where companies or countries that have defaulted on their loans (Does the name Hyflux ring a bell?).

Hence, bonds as a financial instrument would be suited for a conservative investment approach. This is the reason why we are recommended to allocate more of our portfolio to bonds as we age. Furthermore, bonds are income-generating assets rather than growth assets. Hence, if your desire is to have passive income, you may look at bonds as a valid option. 

BUT, if you would refer to my 4% Rule article, you would know that bonds are unable to last you that long into retirement based on historical data. Furthermore, Warran Buffett has not incorporated bonds into his portfolio at his age as well. So you might want to take that into consideration. 

After this long period of voicing my opinion, let's look at the advantages and disadvantages of owning bonds. 

Advantages: 
1. Safe and consistent income - due to the interest rate (coupon) that you will receive
2. Higher on the priority list in the event of liquidation
3. Passive income 
4. Diversify your portfolio as it is a different financial product from stocks

Disadvantages:
1. Lower returns as well
2. Default is still probable
3. Some bonds are not available to retail investors (Some bonds are too high in value, $250,000 for one bond)

These are the priority of bonds payout (A higher priority would mean that you would be paid first in the event of liquidation) 
1. Senior secured bonds (secured means that that debt is backed with collateral)
2. Senior unsecured bonds 
3. Junior Subordinated bonds
4. Guaranteed and insured bonds (The guaranty is from a third-party, but not 100% insured.)
5. Convertible bonds (Can be converted to common stock)

How to find the right bond?
1. Coupon Rate: It is the interest rate paid on the bond (3% of $1000 would be $30)
2. The seniority of the bond: If you have higher priority if the company is liquidated
3. Outlook of the company: If the company is over-leveraged on debt, income statement etc. 
4. Inflation trend: If inflation is at 3% and your bond has an interest rate of 3%, your effective return is 0
5. Liquidity of the bond: If you require money in a short amount of time, are you able to redeem the bond for cash? You can look at the daily trading volume of that bond. 

Thoughts and comments:
As bonds are currently not in my portfolio, I am not that familiar. However, if you wish to diversify your risk, you might want to consider using bond ETFs which has a lower chance of losing your money. 

Sources:
https://www.investopedia.com/terms/b/bond.asp
https://www.dbs.com.sg/personal/investments/fixed-income/understanding-bonds
https://www.investopedia.com/articles/investing/121815/understand-security-types-corporate-bonds.asp
https://www.investopedia.com/articles/bonds/09/bear-on-bonds.asp
https://www.investopedia.com/articles/bonds/07/fixedincome.asp

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Research on the validity of the 4% Rule

Hi friends,

These are the links to the papers and articles that I have referenced in this post:
1. https://www.researchgate.net/publication/228707593_Sustainable_withdrawal_rates_from_your_retirement_portfolio
2. https://www.researchgate.net/publication/50211311_Sustainable_withdrawal_rates_of_retirees_Is_the_recent_economic_crisis_a_cause_for_concern
3. https://www.forbes.com/sites/wadepfau/2018/01/16/the-trinity-study-and-portfolio-success-rates-updated-to-2018/#73f347216860

For those of us that are familiar with the (F)inancial (I)ndependence (R)etire (E)arly (FIRE) movement, you would have heard of the 4% rule. To give you some background, it meant that if you withdraw less than 4% of your portfolio every year, you may withdraw it for the rest of your life. This rule has been used as an important benchmark for those of us in the FIRE movement to determine the asset required in our portfolio.

This is when we should be critical. We should look at how is this rule being derived and the condition(s) that this rule is applicable to our financial situations.

Success/Failure: If the value of the portfolio is positive (>0), it is considered a success
Condition: Stock returns are from the S&P 500, bond returns are from the Salomon Brothers Long-term High-grade Corporate bond index and S&P high-grade corporate composite yield.
Overlapping method: As the data is taken from 1926-1997, there are 53 overlapping periods for 20 years payout, 48 overlapping periods for 25 years payout and 43 overlapping periods for 30 years payout.
The success rate is calculated by (No. of overlapping periods considered successful )/ (Total no. of overlapping periods):

With that, let's jump right in to examine if the 4% rule holds up under scrutiny (P.S.  I will only examine the inflation adjusted monthly withdrawal and I have also learnt my lessons and decided to screenshot these data.)



The percentage in the first row meant that on an annual basis, x% of the portfolio would be withdrawn. The data below means that for y% success rate between 1926/1946 to 1997. For x and y, the higher the better. A higher y would mean that there is a higher chance that our portfolio has a higher chance of having positive sums of money after a set number of years. A higher x would mean that we can withdraw a higher portion of our portfolio (More money for us when we retire)

Discussion of results:
Here we can see some counter-intuitive results. First of all, as we become older, we are often advised to shift a higher portion of our portfolios into fixed-income assets (bonds). BUT as we can see here, a portfolio that is bond heavy would not do as well as its counterpart as the payout period increase. Surprisingly, a higher portion of success can be seen in portfolios that are more focused in stocks.

The idea of just withdrawing 4% also holds up well, more than 70% success rate for the 100%, 75%, 50% and 25% stock portfolio. But when we look at the 100% bonds portfolio, the saying does not hold up for the period of 1926-1997

The idea of just withdrawing 4% does not hold up as well for the period of 1946-1997. The 70% success rate can only be seen in the 100% and 75% stock portfolio.

Hence, if we were to stick to the 4% rule without thinking of our portfolio allocations, we would be really wrong. Asset allocation does matter and the payout period would affect the success rate that our portfolio can sustain our yearly withdrawal rate.

PS: if you wish to check more recent data, do look at the forbes article. They have updated the table with more recent years and included government bonds into their calculation.

Limitations of data:
1. The results are from historical data, hence, it might not applicable to our portfolio when we retire.
2. The bond portion only takes corporate bonds into calculations and not government bonds,
3. There isn't data available for 35/40 years, which is our idea of retirement (assuming we retire at 40, and death at 80).
4. We do not know how much money we are left with. Hence, for those of us that want to leave money for our family, we would have to find another paper for it.

Conclusion:
Reading the paper has challenged my idea that a 4% withdraw guarantees my payout for the rest of my life, regardless of my portfolio. Furthermore, it surprised me that having more bonds in my portfolio would hinder my retirement rather than enhance it.

A possible follow-up to this might include using monte carlo simulations to have a stochastic approach to the study instead of a deterministic model.

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