Brent Sheather: Buffett says do as I say (not as I do)

The Sage of Omaha - Berkshire chairman and CEO Warren Buffett. Photo / AP

This column has been running for almost twenty years. It is normally good fun but once in a while you come across a story that really makes you laugh especially when people or organisations who take themselves too seriously suddenly look, well, stupid. Sometimes it's financial advisors or fund managers maintaining that fees don't matter or that they can defy gravity by investing in alternative assets. Sometimes it is the research manager of FundSource producing research showing that shares have outperformed residential property but only if you forget to include the rental income from the residential property.

Other times it is seeing members of the Code Committee who had been chosen to put together a Code of Professional Conduct for financial advisors including minimum standards of competence, knowledge and skill, resign after Consumer mystery shopped their business and they were found to be giving bad advice. Hilarious.

Occasionally it is the FMA (again) warning all financial advisers to disclose any conflicts of interest then the Productivity Commission comes out with a report saying that many members of the Board of the FMA have too many conflicts of interest. LOL this is a fun job.

Last month one of the highlights was a comment by Warren Buffett in the 2013 Berkshire Hathaway annual report.

But first let's set the scene: much of the personal investment advisory business is built on the proposition that with the help of your stockbroker, investment adviser or whatever you can pick 5 or 10 stocks and outperform all the professional managers and the stock market index. More often than not financial advisers cite the performance of Warren Buffett and Berkshire Hathaway as evidence that you really can beat the market.

I almost fell of my chair this morning when I read Warren's latest annual report where he spoke about the instructions laid out in his will to his wife and trustees as to how they should invest money for Mrs Buffett's benefit after Warren had died. So what did he say - did he tell old Mrs Buffett to rush out and buy a copy of the stock picker's bible, Security Analysis, by Graham and Dodd, study it furiously, pick 10 stocks and go off to the beach?

It's an impressive book, even today, running to about 830 pages and it's sitting on my bookcase opposite. It might even come in useful to throw at a burglar or a rat. Nope. Did he tell Mrs B. to race out the door, do a one day course on charting and then expect to double her money in 5 minutes trading foreign exchange? I don't think so! Surprise, surprise, he didn't say to put the cash into a fund of hedge funds either. Warren is aware of the impact of fees and doesn't believe in alchemy.

What he said was that Mrs Buffett etc should invest 10 per cent of the money in short term government bonds and put 90 per cent into a low cost index tracker fund run by Vanguard. Shock horror! This latest advice from Warren has the potential to spin out stockbrokers, financial planners and private bankers from Auckland to Alaska.

More often than not their financial plans for mum and dad recommend 5 or 6 stocks in each of NZ, Australia and internationally ostensibly selected using Warren Buffett's value based methodology. In practice that usually gets simplified to "buy anything with a high dividend yield" but that is another story. This high risk, concentrated strategy is favoured over buying a market capitalisation weighted portfolio of the 5,000 or so largest stocks in the world via a low cost fund and thus eschews that number one rule of investing, diversification.

Funny too is the fact that usually whenever Warren writes anything it is widely reported by stockbrokers but for some reason there hasn't been a peep about this story from anyone yet - except Vanguard of course. They however must be over the moon as this sort of advertising couldn't be bought. What is more it is good advice and later we will see why but first let's see specifically what Warren had to say; "My money I should add is where my mouth is; what I advise here is essentially identical to certain instructions I have 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 per cent of the cash in short term government bonds and 90 per cent in a very low cost S&P 500 index fund (I suggest Vanguards). 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".

Warren succinctly puts the case for investing in shares via a highly diversified, low cost fund when he states that all the non-professional mum and dad needs to know about investing in shares is that the average American business has done well. Therefore the appropriate investment strategy is to buy that average rather than to try to pick winners. "Neither he nor his helpers can do that - the goal should be to own a cross section of businesses via a low cost S&P500 index fund". Warren also gives readers some more hints as to an appropriate investment strategy. These are:

•That investors should accumulate shares over a long period and never sell when the news is bad

•Investors shouldn't buy and sell frequently despite being urged to do so by those offering advice and effecting transactions because the frictional cost "can be huge and, for investors in aggregate, devoid of benefit".

The wisdom of diversification is quite easy to understand but is, as we have highlighted, frequently ignored. The reason retail investors ignore diversification is probably the same reason people buy lotto tickets - hoping to win big. This false hope of beating the market is of course, in no small way, due to the marketing efforts of the investment industry. But if the biggest investment institutions in the world with teams of analysts, access to the top management of the companies they invest in and real time data can't beat the market what hope has mum and dad in Tauranga got? Not much, even if they have their own private banker.

Even Berkshire Hathaway has underperformed the US stockmarket in the last 10 years. The investment theory says that the outlook for all stocks is similar, adjusted for risk. So because share prices are not perfectly correlated the main benefit of diversification is that you get the same return as owning one stock for a much lower level of risk. When you are retired and living off your income low risk is the name of the game.

Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request.