index funds

IFA's Quote of the Week - 5 (Warren Buffett)

index funds

 

 "Our favourite holding period is forever."

Letter to Berkshire Hathaway shareholders, 1988, Warren Buffett

 Widely known as the Oracle of Omaha, Warren Buffett is one of the most admired investors in the world. Hordes of investors may bend a listening ear to capture Buffett’s every word, but few seem to heed his sage advice to buy and hold. 

Here, Buffett advises that the ideal holding period for investments is “forever”. While many investors do not have the luxury of never selling an investment, IFA’s position is that investments should only be sold when an investor needs the money or if he loses faith in capitalism. IFA further advises its clients to construct a portfolio comprised of a risk-appropriate blend of passively managed index funds. Passively managed funds do not have a fund manager trading stocks to chase sectors and returns. This passively managed fund strategy has significant benefits:

Costs are held to a minimum — no big salaries and excessive trading costs to drive up the expense ratio.

Style purity — stocks are bought and held according to rules of construction that remain constant regardless of market conditions.

Tax-advantaged — buy and hold mitigates against excessive capital gains distributions that trigger a bigger tax bill.

Consistent exposure to risk – buying and holding specific asset class indexes that contain stocks that share the same risk and return characteristics enables investors to maintain an ongoing exposure to the indexes that carry 80 years of risk and return data.

Diversification – Global diversification enables investors to dampen volatility by investing in as many as 17,000 companies in 40 different countries.

The benefits listed above provide compelling support for Buffett’s buy and hold advice and incorporates global diversification to dampen risk. Thanks to the Nobel prize-winning research set forth by Harry Markowitz in 1952, many investors are just beginning to grasp the importance of “not putting all of their eggs in one basket”, and the importance of diversifying risk across multiple asset classes.  

The important figure below shows the benefits of applying Buffett’s buy and hold advice and combining it with Markowitz’s diversification strategy. Specifically, the 20 IFA Index Portfolios plotted on the risk reward chart for the 50-year period from 1957 through 2006. The figure shows how risk, as measured by standard deviation, reduces the longer the Index Portfolio is held. For one-year holding periods, the 20 Index Portfolios show vastly different measures of risk. However, by just holding that same portfolio for two years, you can significantly reduce the risk of obtaining the expected return. And, when Index Portfolios are held for their recommended holding period, the standard deviation of returns for each Portfolio rests at just 4% or less, making the riskiest IFA Index Portfolio that is held for its 12-year recommended holding period only as risky as the lowest risk IFA Index Portfolio held for its recommended holding period of 4 years. This is why investors should first determine their risk capacity, then match that capacity to a level of stock market risk. Finally, they should reap the benefits of time diversification by holding the portfolio for the recommended time period.

Time Diversification of 20 Index Portfolios

To watch the animation of risk reduction over time, please click here.