Berkshire Hathaway v. Optimized Two Asset Portfolio (Large Growth and Small Value)

Warren Buffet is a household name to many that embodies investment wisdom. He has been a pillar of buy and hold investing for more than 30 years. Buffet is a likeable, grandfatherly person who has made a number of quotable statements:

“[Our] favorite holding period is forever. We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint.”

“A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful.”

“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”

“Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold.”

Buffet operates via a publicly traded company, Berkshire Hathaway. So how would an investor do who purchased Berkshire Hathaway stock over time versus a portfolio made up of passively managed mutual funds?

The second portfolio is a combination of a large growth index fund and a small cap value mutual fund. The percentage allocation was based on choosing the efficient frontier as of December 1999. The efficient frontier creates an optimal balance between investments based on either future predicted returns of historical returns. In this case I used the historical performance from 1972-1999 to create an optimal mix of the two funds that works out to 56% Large Cap and 44% Small Cap Value. This way we don’t get any benefit from knowing the next 20 years.

Accumulation Years: 2000-2019

In the year 2000 tech stocks were the rage and the market was at one of its highest valuations ever. What if we started investing at that point, putting $500 per month away into one of the two portfolios for 20 years and adjusting our contribution up for inflation?

Portfolio 1: Berkshire Hathaway

As of the end of 2019 you would have accumulated $438,357. This is not bad considering you had to endure the Dot.com selloff, the Great Recession of 2008, and many other smaller corrections and selloffs.

Portfolio 2: 56% Vanguard Growth Index and 44% DFA US Small Cap Value

As of the end of 2019 your total accumulation is $437,185.

So either one of these portfolios was a very effective tool for building wealth.

Retirement on Buffet or Mutual Funds? 2000-2019

In this next analysis, we take a withdrawal of $416 per month adjusted each year for inflation from an account valued at $100,000 initially. How did we do?

Portfolio 1: Berkshire Hathaway

Our simple Buffet portfolio ends the 20 year period with a balance of $243,135. Berkshire’s low exposure to tech stocks in the Dot.com era did wonders for this portfolio.

Portfolio 2: Large Growth/Small Value

The two asset portfolio ends the period with a balance o $86,035. This portfolio still has a chance to make it to 30 years, but it is definitely at risk of zero balance in the next decade. The Dot.com selloff was very damaging to a US only portfolio that was heavily weighted to growth stocks. This is the danger of optimizations based on history. Higher returning assets will get weighted a heavier amount at the wrong time.

Hussman Strategic Total Return: Tactical Investing Delivers Less (HSTRX)

It is an inescapable fact that we all hate to experience pain and that includes pain from investments losses. Anytime there is a significant selloff in markets, as we are experiencing now, a little voice in our heads starts to whisper “Get out! Get out!” Frequently we encounter various friends who tell us they got out “the day before the crash” or something to that effect. How could we be so stupid?

I like to look at track records of tactical investing rather than anecdotes. When you look at track records, getting in and out of the market just doesn’t work out for many investors. In fact, Morningstar (an investment research service) recently noted that out of 22 mutual funds taking a tactical approach ten years ago, 17 of those funds have either shut down or merged into other funds.

Hussman Strategic Total Return is a fund that has been around for a while. So how well does such a tactical approach work for accumulation and distribution?

Accumulation: Almost 20 years of $500 monthly

Hussman Strategic Total Return has a long history, but falls just short of giving us 20 years. Nevertheless, this is one of the older funds in this class, so we’ll just remember that we are a couple of months short of 20 years.

10/1/2002 - 5/31/2022

$219,450 Balance after 19 years and 8 months

$417,318 Vanguard S&P 500 Index during the same period

Hussman did get ahead briefly during the 2008 crisis, but has dramatically lagged since 2012.

For those willing to just keep at it, the higher-risk exposure to equity paid off by nearly 2x.

Distribution Phase: 5% distributions annually over the same time period

Here we shift to the distribution phase. Now admittedly, this is a very favorable starting point for a retiree because most of the damage from the Dot-com selloff was done by the time the Hussman Fund was born. But we did have to go through the 2008 crisis, Covid-19, and now the inflation-related selloff that we are currently experiencing.

Ending balance:

$69,952 Hussman Strategic Total Return survives 20 years, but will likely run out before 30.

$342, 016 Vanguard S&P 500 Fund comes out looking super. Again, this is greatly impacted by the starting point of October 2002. However, as a retiree, doesn’t it show us that when things are dark, we should still be thinking like buyers rather than sellers even in the retirement phase?

Retirees felt the impact of the 2008 selloff, but for those who simply stayed invested, they far outperformed any tactical approaches.

The All-American Portfolio: AGTHX, AEPGX, ABNDX

If you are a do-it-yourself investor you may not have familiarity with American Funds, but many investors who have worked through an advisor have invested via American Funds. Three of their better known funds are Growth Fund of America (AGTHX), EuroPacific Growth Fund (AEPGX), and Bond Fund of America (ABNDX). The investment allocation in this analysis looks like this:

AGTHX 40%

AEPGX 20%

ABNDX 40%

So how would we do investing with these three instruments for accumulation and distribution phases?

Accumulation Phase: Monte Carlo 20 years

Our hypothetical investor puts away $500 per month for 20 years. I’m using a Monte Carlo simulation for outcomes instead of choosing a particular 20 year period. I’ll review 5 different groups of outcomes using the 10th, 25th, 50th, 75th, and 90th percentile. The 10th percentile group represents poor outcomes and the 90th percentile represents better outcomes.

10th Percentile $296,204

25th Percentile $375,861

50th Percentile $477,894

75th Percentile $605,044

90th Percentile $739,091

20 Years of Saving $500 Monthly

Our poorest outcome at the end of 20 years is a balance of $296,204. Only 10% of outcomes are worse than that. Our best outcome is a balance of $739,091. Again, only 10% of outcomes are better than this. If we use the 25th percentile, we can say that most of the time (75%) the investor ends with more than $375,861.

Distribution Phase: Monte Carlo

In this phase we start with $100,000 and take out 5% per year and see how many portfolios survive random time periods of 30 years. Distributions are adjusted for inflation and the portfolio is rebalanced annually. This allows a 65 year old to have confidence that their portfolio will last as long as they do. Overall, 94.49% of portfolio return sequences had a balance at the end of 30 years. Here are the percentile outcomes:

10th $101,520

25th $359,993

50th $785,484

75th $1,467,633

90th $2,371,430

90% of portfolios had a balance at least equal to the starting amount of $100,000 (but only in nominal, not inflation-adjusted, terms). This is a very good sign as these portfolios were able to increase distributions to account for inflation.

Battling Inflation: Is the S&P 500 Enough?

I don’t blame you. I know that the explosion of investment options has left you with an “I give up” feeling about choosing your investments. According to Morningstar, there are 231 different choices just in the ETF category of Large Cap Blend alone. There are 1206 choices if you choose to invest via mutual funds. Then you have individual stocks as well. So why not just put it all in a fund that tracks the tried and true S&P 500?

What follows is a look at the results of investing in the S&P 500 versus a portfolio that is equally weighted in Large Cap Growth, Large Cap Value, and Small Cap Value. As usual, we will compare two different 20 year periods. In the first analysis, we will contribute $500 per month and look at the final accumulation value. In the second analysis, we will start with $100,000 and distribute $416 per month (about 5% per year) over 20 years and see how things compare. I have chosen the period of 1972-1991. This is a very rough period in our economic history characterized by high inflation and low earnings growth.

Accumulation: 1972-1991

Portfolio 1: S&P 500 The simple portfolio ends the 20 year portfolio with a balance of $1,024,773. Not bad at all!

Portfolio 2: Large Growth, Large Value, Small Value The equal-weighted, three asset portfolio ends slightly higher, with $1,296,514. So diversification gives you about $275,000 more with less risk. The worst year for this portfolio is -24.82% versus -26.93% for the S&P portfolio.

Distribution: 1972-1991

This high inflationary period was devastating to an S&P 500 only portfolio. Just to get a grasp of how dramatic inflation was in this period, your initial withdrawal of $416 per month had to grow to $1378 per month to preserve your buying power! That is more than triple your initial withdrawal.

Portfolio 1 Ending Balance: $18,157

Portfolio 1 arrives at zero in year 22. This is not a long enough payout period for today’s investor unless you start your retirement distributions at age 72.

Adding Large Cap Value and Small Cap Value to the second portfolio significantly improved results. Small Cap Value stocks had an incredible run in this period, including a 10 year stretch in which they averaged over 30% return per year!

Portfolio 2 Ending Balance: $319,167

The diversified portfolio ends the 20 year period in 1991 healthy and at a current withdrawal rate of 5.7%. This portfolio could continue to make distributions even up to today, ending with a balance in 2022 currently of $3,279,659 and a annual distribution amount of almost $33,000 due to inflation adjustments.

Diversification really matters in the retirement phase! Don’t let the plethora of investments overwhelm you. It is worth it to build a broadly diversified portfolio with more than just Large Cap Growth stocks.

Gold v. Large Cap Growth/Large Cap Value/Small Cap Value 1975-1994

I’ve met a healthy number of people who believe that gold is different, that it has some “real” value that distinguishes it from other assets. If you listen to certain radio stations, the radio announcer will tell you that gold holds its value through thick and thin. I’m biased toward other types of investments, particularly equity. I just don’t see the allure of yellow metal when compared with a corporation made up of thousands of problem-solving people creating products and services in order to adapt to a changing world.

For the study period here I chose 1975 to be generous to gold lovers. 1975-1994 was a period of high inflation and gold was still fairly early in its run. Based on personal experience, I imagine the interest in gold peaked in the early 1980’s, but let’s be generous and see how well gold works as an asset for accumulation and distribution. The average annual inflation rate in this period was 5.49%, so this is a great study of a long-term, high-inflation economic period.

The equity portfolio here is not made up of specific funds but rather three asset classes:

Large Cap Growth

Large Cap Value

Small Cap Value

Each of these is equal weighted and rebalanced annually.

Accumulation Period Results

From 1975-1994 Jane Investor put $500 per month into an account in each of the portfolios. Jane was probably feeling pretty amazing about the progress in her gold account by the end of 1980:

Portfolio 1 (gold): $132,410.35

The equity portfolio was going strong, as well:

Portfolio 2: $80,758.80

However, the future for gold dimmed dramatically in the following years. The difference in ending balance of the two portfolios is dramatic:

Portfolio 1: $280,944.77

Portfolio 2: $1,127,706.71

So on an accumulation basis, equities certainly won out here. Gold provided a very modest return (the time-weighted return was 3.67%). The stock portfolio provided a time-weighted return of 17.75%.

Distributions: Can we fund a retirement with gold?

Now we took $100,000 and invested in each of the portfolios. Jane Investor withdrew $416 per month, which amounts to roughly 5% annually. The distribution was increased each year for inflation. The equity portfolio was rebalanced annually.

Portfolio 1: Gold

Almost! The gold portfolio runs out in 1993, one year shy of our 20 year goal. Jane Investor was a fairly early adopter and that helped. If she had invested the gold portfolio in 1980, when gold fever was higher, the funds would have run out in 11 years.

Portfolio 2: Equity

The equity portfolio is alive and well 20 years later with a 20 year terminal balance of $1,699,347.91. All three of the equity classes did well.

Average Annualized Returns 1975-1994

Large Cap Growth 14.76%

Large Cap Value 17.21%

Small Cap Value 23.88%

Equities delivered in a dramatic way with two very big assists. First, stock valuations were very low at the beginning of this period relative to today. The ten-year price-to-earnings(PE) average in 1975 was around 9. Today the ten-year PE average is close to 32. Second, interest rates were falling during most of this period.

MSFT INTC XOM GE CSCO v. DFSVX VIGRX DFEMX (2000-2019)

In 2000 growth stocks had completed an incredible run that left growth stock investors with almost unreal returns. Could it last? Here we have an analysis that takes the top five companies in the S&P 500 from the year 2000 and looks forward 20 years from both an accumulation and distribution point of view.

Portfolio 1 is an equal weighted portfolio of the top five stocks of the S&P 500 in 2000:

Microsoft - Intel - Exxon Mobil - General Electric - Cisco

Portfolio 2 is an equal weighted portfolio of three uncorrelated equity classes:

US Small Cap Value - US Large Cap Growth - Emerging Markets

Accumulation Phase: How did we do?

Both portfolios grew successfully over the next 20 years. Saving $500 per month on an inflation-adjusted basis:

Portfolio 1: $394, 281

Portfolio 2: $407,973

Both of these portfolios do fairly well with wealth accumulation, despite the Dot-com selloff as well as the 2008 Crisis. At the 10 year mark, Portfolio 2 was significantly ahead,

Portfolio 1: $78,657

Portfolio 2: $104,806

If you were crunching the numbers, you would find that the time-weighted rate of return on Portfolio 1 was -1.1% at the 10 year mark, while Portfolio 2 had a time-weighted return of 5.91%.

Nevertheless, the next 10 years was better for the portfolio of individual stocks, with a time-weighted return of 11.5% versus 10.01% for the three funds.

Over the full 20 year period, either portfolio delivers significant growth in wealth, accumulating close to $400,000.

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Distribution Phase: Did we run out of money?

In the distribution phase, we took $100,000 and distributed $416 per month, roughly 5% annually. The distribution amount was adjusted up each year to account for inflation. In this case, the differences are stark:

Portfolio 1: Ran out of money in 2014 due to the Dot.com selloff.

Portfolio 2: Still alive and well in 2019, able to support the income distribution.

Here we see the relative importance of diversification during retirement as opposed to the accumulation years. Many investors turned off by the complexity of Wall Street may decide asset allocation doesn’t matter. That stance may work frequently during the accumulation years, but your risks rise appreciably during retirement.

20 In / 20 Out

I’m writing this blog with the intention of giving readers a chance to see the long-term impact of investing in stocks during both the accumulation phase and the distribution phase. I’ve chosen 20 years as my time period for a couple of reasons: (1) Plenty of mutual funds and ETF’s have been around that long so that we can look at a variety of funds over a number of different periods. (2) I want a 45 year old or even 50 year old to see the power of just 20 years of saving. Further, distributing assets over 20 years will generally show whether the approach is sustainable.

I’d like to choose some of the more popular funds, both actively managed and index funds as well as any ETFs that give us a long enough history. The purpose is to show the power of stocks for building wealth over time. Many investors get overly fixated on the short-term gyrations of the market and think getting in and out at the right time is the key to building wealth. Nothing could be further from the truth. Active fund managers that get in and out of the market have subpar records compared to funds that stay invested. This blog intends to show readers what happens to investors who stay the course.

So many investors are led astray by hucksters claiming to know when the next 80% drop in the market will occur (btw - an 80% drop in the market overall has only happened once, during the Great Depression). Experts tell us the market is “extremely overvalued” frequently. There are pundits and managers who have been saying such things for the last 25 years!

Investing in stocks is not some intangible lottery ticket. It means purchasing a small piece of ownership in a business in the United States or abroad. Your ownership share may be extremely small as a part of the whole, but you receive the same benefits on a proportional basis as a person who owns a large stake in the corporation.

During the contribution phase I’ll assume a savings rate of $500 per month. If you are under the age of 50, this is the maximum IRA (Roth or traditional) contribution if multiplied by 12 months. I’m allowing the scenario to increase the amount of the contribution to account for inflation. If the US government doesn’t increase the allowable IRA contribution, you could always do your saving in a 401k or taxable investment account.

During the distribution phase I’ll assume a withdrawal of 5% of the account balance as the starting amount and adjust for inflation. I’ll have withdrawals come out monthly since that is the way most of us manage our bills. If the money runs out using that method, we’ll lower the distribution until the money lasts and note the portfolios and distribution percentages that work.

I’ve already worked with the numbers enough to propose what you’ll see as these scenarios unfold:

1. 20 years of saving in equity funds adds up to a lot of money, even if you start at a market high or don’t have a highly diversified portfolio.

2. Most of the time investors can withdraw 5% of their assets from their portfolios annually, but this becomes dicey if their portfolio is concentrated in one particular type of stocks. So I would posit that diversification is more important during the distribution phase than it is during wealth building.

3. The winner (the best outcome) will be dependent on the period, not the manager or index type. There are periods when US Large Growth shines and times when investors are much better off in foreign or small company equities.

I will integrate bonds at times, but this blog will be concentrating on equity rather than fixed income. Bonds can be of great benefit to investors, but the long-term benefits of equity investing are unmatched.

I may use asset class returns at various points in order to use some older period returns. There is always the fear that we might revert to some darker period in history, so I’ll try to look back as far as possible in order to assuage that fear.

Thanks for taking the time to read. I’m hoping you find encouragement from this to stick with equities and not be rattled by the financial media that predicts calamity around every corner.