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Investment Fundamentals According to Buffett
“The most important quality for an investor is temperament, not intellect.”
—Warren Buffett, Rules That Warren Buffett Lives By
Introduction
When you first started school, you were taught the “3 Rs”—reading, 'riting, and 'rithmetic. Okay, for those grammatical purists out there (i.e., “grammandos”), let's relabel them as reading, writing, and arithmetic (math). These three subjects were the foundation for most of the subjects you learned from elementary school on. Most public schools and many private schools use what's known as the Common Core, a more detailed framework on what should be taught in math and language arts/English classes. Well, there's a core set of concepts in financial literacy, and we're going to tackle some of them in this chapter. And by the end of this book, we think you should consider yourselves financially literate, if you didn't just skim the summary sections. :-)
You've probably heard the expression “Time is money.” Financial folks twist this around a bit, saying, “There is a time value to money.” One easy way to understand this concept is that if you have some cash, let's say $100, you could put it in the bank and earn interest, a concept we mentioned in Chapter 1. The $100 will grow to something more than $100 over time. The exact amount depends on the interest rate. The bank takes the money you deposited and lends out most of it to people who need money, known as borrowers. The borrower might need the money for a car loan, student loan, home loan, or a whole host of other reasons. Borrowers could also be companies or governments. A loan on a home or building is known as a mortgage.
The interest rate is one form of what is called the return on an investment. The return is the amount at which your money grows if you make money or falls if you lose money. So a return could be computed when you put your money in the bank, to buy a stock, house, or many other things. It's the number that is one of the main drivers of your net worth. But let's just stick with the notion of interest rates for now.
The “Miracle of Compound Interest” Explained
Let's go back to the fictional $100 you deposited in your local bank. Assume the annual interest rate is 3%. One year later, if you look at your account balance, it will be $103. And one year after that, assuming you kept your money in the bank, it would grow another 3% to $106.09. For those not comfortable with math, we'll keep any equations in this book to a minimum. Any equations that can't be explained in plain English will be relegated to a endnote or Appendix. The general equation, known as a Future Value formula, is that the value a year from now equals today's value times one plus the return on investment raised to the T power. T refers to time and is one year in our example.
One of our Tips from Chapter 1 was “Start early.” Let's see the dramatic effect of how money can grow into the future using the Future Value formula, especially over long periods of time, with the “miracle of compound interest” we referred to in Chapter 1. Due to advances in medicine, one study finds that about a third of people born today will live to be at least 100. So, even though it might be the furthest thing from your mind, you should plan on living into the triple digits!
Let's see what happens if you put aside $10,000 when you're 20 (or 20 at heart) and look at what you'll wind up with when you're 100. For those over 20, we'll assume in this example that you are part vampire (spoiler alert), like Kristen Stewart's character in the Twilight series of films. Yeah, we know $10k is a decent amount of cash to have at 20, but it’s possible if you work hard and save early. We have the starting value, $10,000. We have the time period, 80 years. All we need is the rate at which your money will grow, or compound.
Let's do the calculation for two strategies. First, we'll put it in a basket of smaller stocks selling at a discount, known as small cap value stocks in the financial world, and assume it gives us its historical return of 14% a year. We'll go into more detail on small cap and value in Chapter 5, but let's continue with our example. For the second strategy, we'll give it to Buffett to invest, or a clone of Buffett, which earns his historical return of 20% a year.
What do you think you'll wind up with at the end of 80 years? A few million dollars? Try almost $357 million for the first strategy of small stocks! And the Buffett strategy? How about $21.6 billion! Figure 2.1 shows the amazing results. The picture illustrates that the bulk of the money made occurs near the later years. That's why it's really important to start early. What's that saying? The early bird gets the worm? Indeed!
Another issue related to the time value of money is that you often receive money in the future and must decide how much to pay for it today. For example, in Chapter 4 we'll talk about US Savings Bonds issued by the federal government. With a savings bond, you purchase it at a discount to its face value and it accrues or gathers interest monthly. If you purchase the most common savings bond, known as EE, the US government guarantees it will at least double over a 20-year time period. You can think of it as a loan you give to the government.
Let's look at the reverse of the example we did a bit earlier. If someone will give you $100 one year from today, how much would you pay them now? We hope you're thinking something less than $100 to account for the time value of money concept that we just discussed. The exact amount depends on the interest rate, also known as the discount rate in this type of problem, since you are applying a discount to something that you expect to receive in the future. When we flip around our Future Value formula and solve for the amount we'd pay for something today, it's known as the Present Value formula. Using the same 3% interest rate, to get the Present Value we divide the Future Value by one plus the interest rate raised to the T power. Once again, T stands for time, or 1 year in our example. Crunching these numbers, we calculate you should be willing to pay a maximum of $97.23 today to receive $100 a year from now. Anything less than $97.23 might be considered a good deal.
Figure 2.1 $10,000 Invested With Buffett or in a Small Cap Value Index Fund Over 80 Years.
Trade-Offs: A Fundamental Principle of Life
When you were a little kid perhaps your parents or a teacher read to you some of Aesop's Fables such as The Hare and the Tortoise, The Fox and the Grapes, or The Wolf in Sheep's Clothing. Aesop was around a long time ago, and we mean ancient. Like more than 2,400 years ago! As you can imagine, recordkeeping wasn't that great at the time, so one version of Aesop's bio is that he was a slave who lived in ancient Greece from 620–564 B.C. He was apparently freed due to his magnificent storytelling abilities, which eventually turned into the more than 600 fables that he is today credited with creating.
One of Aesop's Fables, The Hawk and the Nightingale, has the famous quote “A bird in the hand is worth two in the bush.” This trade-off, a certain meal today versus the prospect of a bigger meal in the future, is the essence of investing. Buffett said, “The formula for value was handed down from 600 BC by a guy named Aesop. A bird in the hand is worth two in the bush. Investing is about laying out a bird now to get two or more out of the bush.”
Of course, Buffett wants us to think about dollars rather than birds. He said something similar in another one of his shareholder letters, using the important term inflation, which we mentioned in Chapter 1 and will discuss in more detail in Chapter 3. He said, “Investing is laying out money now to get more money back in the future—more money in real terms, after taking inflation into account.” Investing is a core financial literacy skill, so let's put that as one of our Tips.
A famous study, known in academic circles as The Marshmallow Experiment, showed the enormous effect delayed gratification, or waiting for something good, can have on your life. In the 1960s Professor Walter Mischel of Stanford University (a university on par with, if not better than, the Ivy League schools) tested hundreds of 4- to 5-year-old kids and tracked how they turned out decades later.
Here's the experiment Professor Mischel tried on the kids. He, or a member of his research staff, had a kid come into a room and offered them a marshmallow. We'd prefer a Snickers or Twix bar, but let's continue with the story. He said he had to leave the room for a little while but that if the marshmallow was still there when he came back, he'd give the kid two marshmallows. Sort of like a marshmallow in the hand versus two in the bush, or in the waiting room.
He left the room for about 15 minutes and then came back. Some of the kids couldn't resist and ate the marshmallow right away. Others waited a bit but couldn't last the full 15 minutes. And yes, some of the kids were able to wait the full 15 minutes. Let's assume these kids liked marshmallows too but had greater self-control and what we termed as a delayed gratification element of their personality.
The key to the story isn't what happened with the marshmallow but what Professor Mischel found after he tracked how the kids turned out decades later. The kids who were able to wait the full 15 minutes (i.e., those who exhibited delayed gratification skills) wound up with better SAT scores, lower levels of substance abuse, and better social skills and scored better on a number of other positive life measures. The results held true over 40 years later!
You've probably heard the expression “Patience is a virtue.” Well, that concept certainly holds true for being a successful investor as well. Buffett said, “The most important quality for an investor is temperament, not intellect.” Temperament is one of those SAT/ACT words that means your nature, makeup, or disposition. And being patient and not being swayed by the crowd are two characteristics often associated with financial success. Buffett's comments on temperament merit a Tip.
Tying this Tip back to the time value of money graph: The longer you wait to spend your money, the more money you'll have down the road because it's able to grow or compound over a longer time period. That snowball rolling downhill that we mentioned in Chapter 1. And, of course, if you didn't save anything, you would have no money down the road. So the trade-off is between something good today and the likelihood of something even better down the road, be it tomorrow, or next month/year/decade.
The Saint Petersburg Paradox: A Lesson on Risk and Return
Saint Petersburg is a city in Russia located near the Baltic Sea. In 1713 a famous mathematician by the name of Nicolaus Bernoulli created an example similar to the one we'll discuss below. Stick with it—it has a real punch at the end!
Bernoulli said, let's flip a fair coin until the first head appears. A fair coin has heads on one side and tails on the other, each with a 50% chance of appearing. If a head appears on the first flip you get $2. If the first head appears on the second flip (which means the first flip was a tail and second flip was a head) you get $4. If the first head appears on the third flip you get $8. The general formula is that if the first head appears on the nth flip, you get $2n. In theory, you could flip the coin forever, even though the likelihood is that a head would appear on the first handful of coin flips. So how much would you pay to participate in this coin flipping game?
There is no exact answer, but most people say something between $2 and $10. But let's compute the expected return or value on this game. The probability of a head appearing on the first flip is 50%. If you multiply that by the payoff in the first case, $2, you get $1. The probability of the first head appearing on the second flip is ½ times ½, or 25%. If you multiply that by the payoff in the second case, $4, you get $1. The probability of the first head appearing on the third flip is, ½ times ½ times ½, that is 1/8th, or 12.5%. If you multiply that by the payoff in the third case, $8, you get $1. Hopefully, you can see the pattern here. You get $1 in each case and since theoretically you can flip the coin forever until the first head appears, you get $1 added to each case stretching out to infinity! In other words, the expected value or return is infinite!
But most people are willing to pay less than $10 for this game. How can we reconcile the two values—infinity versus less than $10? Well, the risk of the game is also infinite, if risk is calculated by a measure of dispersion, known as variance, or its square root, standard deviation. There are a lot of ways to measure risk, including Buffett's definition that we'll get to in a moment. Intuitively, in this game there is a good chance a head will appear on the first few flips, so that's why most people are willing to pay less than $10 for the game. But there is a very small chance you could go dozens if not hundreds of flips before the first head appeared, resulting in a potentially huge payoff.
So the point of the St. Petersburg paradox is that potential risk is just as important as return when you're picking investments—and with many other things in life as well.
Risk and Return: The Evidence
The notion of investing has been around since the beginning of time. You'd think we'd all agree on how to measure or define risk. Well, we don't. Just like we can't agree on the best musician of all time, the best movie, best athlete, and so forth. If you talk to the average person on the street—that means you—most people define risk as the chance of losing money or the chance of not meeting an important goal, such as going to college or paying their rent. Buffett, using the definition from the dictionary, describes risk as “The possibility of loss or injury.” Let's put that as our lucky Tip number 13.
We don't disagree with him, or with the dictionary definition, but examples like that are hard to pin down numerically, so economists typically focus on something they can measure more precisely, such as the standard deviation term from statistics we mentioned a few moments ago. Something with small dispersion or variation has little risk according to the standard deviation measure. Like the change in the temperature across seasons in Hawaii or San Diego. Nearly always nice and sunny. Something with wide dispersion has a lot of risk according to the standard deviation measure, like the change in the temperature across seasons in Canada. Often it's either freezing cold—for much of the year—or warm and sunny, during the summer.
There's a whole range of investments, but let's consider the three biggies: stocks, bonds, and cash. Of course, there is no guarantee that the past will be exactly like the future, but using data that spans about 100 years, researchers have found that there is a long-term relationship between risk and return. And we mean looooong. Sometimes it takes more than 10 years for the relationship to work! By “work” we mean that over long periods of time low-risk investments deliver the lowest returns, while high-risk investments deliver the highest returns. Buffett has somewhat of an issue with this viewpoint when you take inflation and taxes into account, but we'll leave that story for another chapter.
In the short run, the exact opposite often occurs! That is, in the short run, it's possible for low-risk investments to have the highest returns and for high-risk investments to have the lowest returns. Therefore, you need patience to be successful at investing.
And Buffett has a lot of quotes on patience, besides our Tip 12 on temperament. Here're a couple of our favorites, including one that's PG rated. “The stock market is a device for transferring money from the impatient to the patient.” Another is “Successful investing takes time, discipline, and patience. No matter how great the talent or effort, some things just take time: You can't produce a baby in one month by getting nine women pregnant.” Let's put a shortened version of this quote as Tip 14.
Let's get back to those three broad investment categories: stocks, bonds, and cash. Cash not only refers to cash in your hand or in the bank but also cash-like investments, such as short-term income securities issued by the US government, known as US Treasury Bills, or T-Bills for short. These investments are incredibly safe since they are backed by the government and pay off in less than a year. The government can always raise taxes or run the printing press to pay its bills. Table 2.1 shows that T-Bills historically had the lowest return (3.3%) of the three categories but also the lowest risk as measured by standard deviation (3.1%). Of course, recently the returns have been a lot lower, close to zero in fact.
Next up is bonds. Bonds are issued when a company or a government borrows money from investors. They have an expiration date lasting from more than 1 year to up to 30 years. Very rarely will you see a bond that lasts more than 30 years in the US, although the US Treasury periodically floats the idea of issuing a 50- or 100-year bond.
Due in part to the long period of time you have to wait to get your money back, these bonds are riskier than T-Bills, even when issued by the same entity (i.e., a government or company). As can be seen in Table 2.1, US government bonds of intermediate maturity (i.e., 5–10 years) historically provide higher returns than T-Bills (5.1% vs. 3.3%), but also higher volatility (a standard deviation of 5.6% vs. 3.1%).
Table 2.1 Risk and Return in the US: 1926–2019
Source: Morningstar.
| Investment | Annual Return | Annual Standard Deviation |
|---|---|---|
| Treasury Bills | 3.3% | 3.1% |
| Government bonds | 5.1% | 5.6% |
| US stocks | 10.2% | 19.8% |
Saving the best for last, we get to stocks, specifically, US common stocks. Stocks have the highest volatility (standard deviation of 19.8%), but they also have the highest historical return (10.0%). Stocks can be insanely volatile but, if you have the patience to stay the course, a basket of them usually turns out well in the long run.
Diversification: One of the Few Free Lunches in Life
Who doesn't like a free lunch? Well, there's a free lunch in finance, and it's called diversification. Diversification means spreading your money across many investments and not just one or a limited few. It reduces your risk, while not necessarily reducing your return. People have known intuitively about the benefits of diversification for a long time. You've likely heard the expression “Don't put all your eggs in one basket.” It means that if you have everything riding on a single stock, piece of real estate, farm, and so forth, and something goes wrong, you're in big trouble—if not wiped out. However, if your investments are diversified across many assets, a disaster for one investment doesn't mean your entire portfolio is ruined.
One early person who said not to put all your eggs in one basket was the renowned author Miguel de Cervantes in his classic book, Don Quijote de la Mancha. Don Quijote (or Don Quixote) is on the required reading list in most high school programs and is considered by many literary scholars to be one of the greatest books ever written. Cervantes wrote (translated from Spanish to English), “It is the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket.”
Speaking of great writers, another staple of high school English or language arts programs is William Shakespeare. Shakespeare was also down with the importance of diversification. In The Merchant of Venice he wrote, “My ventures are not in one bottom trusted, nor to one place, nor is my whole estate upon the fortune of this present year. Therefore, my merchandise makes me not sad.”
Yeah, we know Shakespeare's writing sounds weird. That's how people in England spoke in the late 1500s. Fortunately, we'll stick to conversational English in this book. In The Merchant of Venice, Shakespeare's character Antonio basically said his business interests are diversified across many places, as well as across time. This diversified portfolio of investments, or business activities, allowed him to not worry too much in case something went wrong with one of his businesses.
Diversification can provide you with peace of mind. You've probably seen a Chase Bank branch near your home. It's a division of JPMorgan Chase & Co., one of the largest banks in the world. We'll come back to J.P. Morgan in Chapter 9 in our discussion of some of the most important businesses today. Anyway, there was a real person, J.P. Morgan, who was the most famous banker in the world in the early 1900s. He looked kind of like the banker in the game Monopoly. One story says that a friend of Morgan's approached the banking legend in a distressed mood. He said the ups and downs in the stock market didn't let him sleep well at night. J.P. Morgan supposedly uttered the famous phrase, “Sell down to the sleeping point.” That is, make changes to your portfolio so its ups and downs will allow you to sleep easy at night. The changes usually entail a plan for dialing down the portfolio's risk.
In practice, this plan might include diversifying your money across different types of investments, such as stocks, bonds, cash, and real estate, as well as diversifying within each segment. For example, owning a basket of stocks spread across different sectors, such as technology, financials, energy, health care, and others, may result in less risk than owning all technology stocks. Industries don't always move in the same direction with each other since they are affected by many factors, such as government policies and consumer demand. And speaking of demand …
Supply and Demand Determine Price
What determines the price of something you buy? A lot of things factor into it, but it can be succinctly summed up in two words, supply and demand. Supply is the amount produced of the product or service. It could be the amount of cars, cell phones, houses, shoes, or a raft of other things that are produced. Demand is the willingness and ability to pay for a good or service. So you might want to buy a new Ferrari, but it wouldn't count toward demand if you couldn't afford it. A more realistic example is the price you would be willing to pay for a Taylor Swift, Drake, or U2 concert ticket.
Let's consider four possibilities. First, if something is in high demand and the supply is constant or lower, its price will usually go up. Going back to the concert ticket example, the number of seats in the arena are fixed, so, in order to snag a ticket, you're probably going to have to pay up. Bummer!
Second, if something is in low demand and its supply is constant or higher, its price will usually go down. Think about unpopular clothes, bought out of season. Let's say a sports jersey or hat for a team that won't exist for much longer. Like the Oakland Raiders of the National Football League (NFL), which recently moved to Las Vegas. You could probably get a good price searching the bargain bin for these items if you still wanted to wear them this season. Yeah, we know, some people might consider them vintage or throwback jerseys, but most won't want them.
In the other two cases, high demand and high supply or low demand and low supply, it's hard to tell what the effect on the price will be. It could be higher or lower than its historical price. A simple diagram can give us a feel if the price of an item will go up or down. Drum roll … it's called a supply-demand diagram. A sample one is shown in Figure 2.2.
Figure 2.2 Supply-Demand Diagram
There's a simple way to remember which way each part of the diagram flows. Demand starts with a D, and the line (or sometimes curve) goes downward. This means that with most products and services, if the price falls, you would want more of it. Let's say a pair of LeBron's Nike sneakers were selling for only $20. Sign us up for a dozen pair! Conversely, if those Nike sneakers were selling for $500 a pair, we'd move to the sidelines. Sorry, LeBron. Maybe we'd scout out a pair of Steph Curry Under Armours at a much lower price instead.
The slope of the supply line moves up and to the right, in a northeast direction. There isn't a trick (or mnemonic) as catchy as D for demand, but we'll give you something. How about S for stars. Stars are in the sky and most people are right-handed (sorry, lefties) so if you point to the stars, you are probably pointing up and to the right. If the price for selling a product or service is high, especially relative to the cost of producing it, companies will try to crank out a bunch of the stuff. Like someone selling snow shovels and salt during a snowstorm. Or an umbrella in a rainstorm, if you're not from an area where it snows. Or a mask during the COVID-19 pandemic. On the flip side, if you can't receive a price for your product or service that is higher than its cost, you wouldn't supply much of it, if any, since you'd be forcing your firm to incur losses.
It's the intersection between the upward sloping supply curve and downward sloping demand curve that determines the price of a good or service and amount supplied in the end. By “the end” we mean a term economists call equilibrium. It means that there is a state of balance between those demanding a good and those supplying it. Equilibrium doesn't last forever, since the world changes.
A simple way to think about the intersection of supply and demand determining price is to visualize scissors. Which blade of the scissors does the cutting? It's sort of a trick question. It's not one blade that does the cutting, but rather both working together. So, there you have it; the only way to for something to have a stable price is to simultaneously consider supply and demand in equilibrium.
Summary on Financial Fundamentals
Let's wrap this chapter up. In it we covered a lot of the fundamentals of financial literacy. Things like compound interest, diversification, supply and demand, and the relationship between risk and return. We'll come back to these concepts throughout the book and—sorry to break it to you—you'll run into them for the rest of your life when you make financial decisions. But armed with some of Buffett's tips, such as the importance of having the right temperament and patience, you should wind up on the right side of the financial scorecard. And you can take that to the bank!
References
- Aesop. Aesop Fables. Franklin Center, PA: Franklin Library, 1984.
- Bernoulli, Daniel. “Exposition of a New Theory on the Measurement of Risk.” Econometrica 22, no. 1 (1954): 23–36. https://doi.org/10.2307/1909829.
- Bingham, John. “Two Thirds of Today's Babies Could Live to 100,” December 12, 2013. http://www.telegraph.co.uk/news/health/news/10511865/Two-thirds-of-todays-babies-could-live-to-100.html.
- “Buffett on Aesop's Formula for Value.” The Investment Blog, November 12, 2009. http://theinvestmentsblog.blogspot.com/2009/11/aesops-formula-for-value.html.
- Chen, James. “Time Value of Money (TVM) Definition.” Investopedia, April 21, 2020. https://www.investopedia.com/terms/t/timevalueofmoney.asp.
- Clear, James. “The Marshmallow Experiment and the Power of Delayed Gratification.” JamesClear.com. Accessed June 14, 2020. http://jamesclear.com/delayed-gratification.
- Dzombak, Dan. “25 Best Warren Buffett Quotes.” The Motley Fool, September 28, 2014. https://www.fool.com/investing/general/2014/09/28/25-best-warren-buffett-quotes.aspx.
- Herbison, B.J. “Notes on the Translation of Don Quixote.” Herbison Consulting, March 28, 2009. https://herbison.com/herbison/broken_eggs_quixote.html.
- Kaplan, M. Lindsay. William Shakespeare, Merchant of Venice: Texts and Contexts. Boston: Bedford/St. Martin's, 2002.
- Loomis, Carol. Tap Dancing to Work: Warren Buffett on Practically Everything, 1966-2012. London: Portfolio Penguin, 2014.
- Popik, Barry. “Sell Down to the Sleeping Point.” The Big Apple, October 2, 2008. http://www.barrypopik.com/index.php/new_york_city/entry/sell_down_to_the_sleeping_point_wall_street_proverb.
- Rose, Autumn. “10 Billionaires Give Their Best Advice on Getting—and Staying—Rich.” Business Insider, April 20, 2016. https://www.businessinsider.com/10-billionaires-give-their-best-advice-on-getting-and-staying-rich-2016-4.