Buffett’s Asset Allocation Advice: Take It … With A Twist

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Javier Estrada

University of Navarra, IESE Business School

October 26, 2015

Abstract:

One of the most important decisions retirees need to make is the asset allocation of their portfolios. They can have a static or a dynamic allocation, and simplicity usually favors the former. Warren Buffett recently added another vote for static allocations by revealing that he had advised a trustee to split the bequest his wife will receive 90% in stocks and 10% in short-term bonds. The evidence discussed here shows that, relative to other static allocations, a 90/10 split has a very low failure rate and provides investors with very good upside potential and downside protection. The evidence also shows that two minor twists to the 90/10 split result in two very simple dynamic strategies with even better upside potential and downside protection.

Buffett's Asset Allocation Advice: Take It ... With A Twist - Introduction

Retirees need to carefully balance the risk of spending too much and outliving their savings with the risk of spending too little and lowering their lifestyle unnecessarily. The two main tools they can use to avoid falling on either side of the cliff are the portfolio’s withdrawal rate and asset allocation. Regarding the latter, in his 2013 letter to Berkshire Hathaway shareholders, Warren Buffett discussed the simple advice he gave to the trustee that will manage the bequest his wife will receive:

“What I advise here is essentially identical to certain instructions I’ve laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife’s benefit … 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. (I  suggest Vanguard’s.) I believe the trust’s long?term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high?fee managers.”

Buffett does suggest in his letter that investors should follow a simple approach, passively investing in a broadly?diversified, low?cost portfolio; he does not suggest or imply, however, that investors should have a 90/10 stock/bond allocation. And yet his comment begs the question: Is the asset allocation Buffett advised for his wife appropriate for other investors? If yes, why? If not, why not?

An obvious distinction between Buffett’s wife and the average investor quickly comes to mind. The average investor needs to implement an asset allocation that carefully balances the two risks already mentioned, overspending and underspending. Buffett’s wife, however, is likely to receive a nest egg large enough so that she will not have to worry about either risk. Put differently, just about any asset allocation will enable Buffett’s wife to live comfortably and still outlive her portfolio, which is not the case for most investors.

That said, this article evaluates the merits of the 90/10 allocation that Buffett advised for his wife, relative to other static allocations with different stock/bond proportions, for investors at large. Furthermore, it explores two minor twists to the 90/10 allocation, one that accounts for the behavior of the stock market, and the other that accounts for the relative behavior of the stock and bond markets.

In a nutshell, the evidence discussed here suggests that, besides having a very low failure rate, the 90/10 allocation results in an interesting middle ground between the upside potential of more aggressive static allocations and the downside protection of more conservative static allocations. Perhaps more interestingly, the minor twists considered result in two very simple dynamic strategies that increase both the upside potential and the downside protection of the 90/10 allocation suggested by Buffett.

The rest of the article is organized as follows. Section 2 discusses in more detail the issue at stake; section 3 discusses the evidence, first considering several static strategies, and then considering two simple twists to the 90/10 allocation; and section 4 provides an assessment.

The Issue

The two main variables a retiree can adjust when managing his nest egg, the portfolio’s withdrawal rate and asset allocation, have both received considerable attention from academics and practitioners. Bengen (1994) pioneered the research on sustainable withdrawal rates by introducing the ‘4% rule’ for withdrawals, and a massive literature soon followed.1 Interest in asset allocation during retirement is more recent but has also received wide attention. Estrada (2016) reviews and discusses both issues in some detail.

In terms of asset allocation, retirees can choose between static or dynamic strategies. The former implies a constant proportion between stocks and bonds to which the portfolio is rebalanced periodically; the 60/40 stock/bond allocation arguably is the most popular of these strategies. The latter implies an asset allocation that changes over time, which may be implemented in at least two ways. One is to have the asset allocation evolve in a predetermined fashion, such as in the ‘age?in?bonds’ rule;2 the other is to have the asset allocation tied to valuation, typically (but not exclusively) focused on the stock market, so that the weight of stocks is relatively high (low) when the market is cheap (expensive).

Needless to say, both static and dynamic strategies have pros and cons. Static strategies are simple and require little information. However, they may get increasingly difficult for retirees to maintain if the allocation is aggressive (think a 90/10 split for an 70?year old individual with a modest portfolio) and ignore valuation considerations even in extreme situations (think December, 1999).

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