A Simple Method To Outperform Buffett's Heirs

Joseph Hogue's picture

Tuesday, September 30, 2014 - 12:00pm

by Joseph Hogue

You do not get to be one of the world's wealthiest investors without being able to make some pretty amazing deals. Shares of Berkshire Hathaway (NYSE: BRK-A) have returned an annualized 18.7% over the last three decades and it is in no small thanks to Warren Buffett's stock market prowess.

So when people ask, "Is it possible to beat Buffett at picking stocks?" the answer is usually, "not likely."

Of course, that is why his advice is so closely followed and why I spend hours every year studying the annual shareholder report he pens for Berkshire investors.

In his most recent letter, Buffett laid out a set of instructions for his estate and what I saw was shocking -- a rare opportunity to set up a portfolio that can beat the Oracle of Omaha.

Warren Buffett and the Simplest of Investment Strategies

On page 20 of the Berkshire annual report, Buffett lays out a plan for what will happen to a bequest for his wife.

"My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund."

The advice, coming from possibly the world's greatest investor, may seem overly simplistic, but it is more apt for someone with much less investing acumen. Buffett's intent is to provide a hands-free solution that will allow his wife to live comfortably throughout her retirement.

While nearly all the income and growth in the portfolio comes from the allocation to stocks, he includes short-term government bonds to cover withdrawals during times of market weakness. Holding short-term, liquid bonds will allow his wife to continue withdrawing from the account without having to sell stocks when the market panics.

Buffett tells CNBC's Becky Quick that the portfolio will provide, "decent returns," for someone that is not an expert in stocks. The return on this simple portfolio has been very decent indeed. Over the last ten-years, the 90/10 split would have provided a total return of 7.6% a year with volatility that was 10% lower than the general market.

But you can do better.

Beating the Oracle of Omaha

While the allure of holding just two investments may attract some investors, especially the most risk-averse and passive among us, there is reason to believe that the two-asset portfolio is too simple.

But not by much.

By modifying the investments slightly and adding one asset, you can create a portfolio that has outperformed Buffett's Two-Asset plan over the long-term and provides more than three times the income.

First, the S&P 500 fund. The investment allocates money across some of the largest and most stable companies in the world. The problem is that once these companies achieve such a massive size, their growth has slowed dramatically. Substituting the market fund with the Vanguard Small-Cap ETF (NYSE: VB) provides higher growth at only a marginal increase in risk. Over the last ten years, the small-cap fund returned an annualized 10.1% against a return of 8.2% for the general market. The fund holds a diversified mix of 1,475 companies and charges an expense ratio of just 0.09%, lower than 93% of the funds in its category.

While I understand the reasoning behind the government bond allocation, I think it is way too conservative and it actually loses money on an inflation-adjusted basis. Two-year treasury bonds pay a yield of just 0.57% and one-year bonds offer less than a tenth of a percent. Investing in a mix of these means you lose nearly 1.3% a year to inflation.

I prefer the iShares iBoxx Investment Grade Corporate Bond Fund (NYSE: LQD) which holds a mix of more than a thousand bonds in the most highly-rated companies. The fund pays a 3.5% yield and charges just 0.19% a year. Over the last five years, the fund has returned an annualized 6.5% against an annual return of 0.9% for short-term government bonds. While the corporate bond fund is riskier than government bonds, the fund is negatively correlated with the small-cap fund -- providing good diversification when combined in a portfolio.

For additional return and income, I would add a real estate fund to the portfolio as well. Despite the few years around 2008, no other asset has been as widely-held or provided the kind of legacy returns as real estate. The Vanguard REIT ETF (NYSE: VNQ) holds shares of 138 publicly-traded real estate investment trusts, or REITs, and charges just 0.1% for expenses, less than 92% of the funds in its category. The fund pays a yield of nearly 3.0% and has matched the return on the S&P 500 over the last five years.

The table below compares returns and risk for Buffett's 90/10 portfolio and the alternative three-asset portfolio.

  1-yr Portfolio Return 5-yr Portfolio Return 10-yr Portfolio Return 5-yr Portfolio Risk
Buffett 90/10 17.0% 14.1% 7.6% 14.3%
Three-Asset Alternative 10.9% 14.5% 8.9% 17.3%
Source: Yahoo! Finance, analyst calculations

The three-asset portfolio beat Buffett's 90/10 split over the longer periods while underperforming over the last year on recent weakness in small caps. While the alternative portfolio is slightly riskier than the two-asset approach, I think the much higher income more than makes up for the heightened risk.

The chart below compares income from the two approaches on a portfolio value of $1 million. The three-alternative would have provided an average quarterly income of $27,769 over the last five years compared to an income of just $8,034 from Buffett's simplified portfolio. While the three-asset portfolio may be riskier, it provides more than enough income to ride out weakness in any of the assets without having to sell when prices are falling.

Of course, many would say that adding another asset or two would diversify the portfolio further and possibly add to returns. The case could be made for adding a commodities fund or a fund with exposure to master limited partnerships (MLPs). The idea of creating a simplified portfolio with the least number of moving parts and with a minimum of risk is an attractive one, just make sure you are not sacrificing returns for simplicity.

Risks to Consider: Buffett's recommended portfolio, and even the alternative above, is only for the most passive and risk-averse investors. While this type of portfolio may provide for living expenses for the retiree, it may not achieve the growth needed for those with higher financial goals.

Action to Take --> Simply structured portfolios can be attractive for the passive investor but make sure you are not going too far. Add bonds, stocks and real estate for strong income and returns that would make even the Oracle of Omaha jealous.

The goal of Buffett's portfolio is to provide solid returns with minimal effort -- another alternative is to buy "Forever" stocks. These are world-dominating companies that have such a solid foundation and strong long-term growth potential that you can literally buy shares and hold them forever. With this in mind, we've identified a list of 10 Forever Stocks that we think are the absolute best to own right now. To learn how to get the full list, visit this link.

Joseph Hogue does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.