Warren Buffett says equity investors should prepare to see their portfolios halve in value – but shouldn’t be concerned about such short-term volatility as it is simply the price they must pay for the long-term outperformance of assets such as cash and bonds.
Writing in his annual letter to shareholders, the Berkshire Hathaway chairman pointed to four major corrections in the company’s shares since inception, ranging from 37.1 per cent in 1987 to 59.1 per cent between 1973 and 1975, and said they will experience similar declines over the next 53 years as well.
Berkshire Hathaway's biggest share-price falls since inception
Source: Berkshire Hathaway
“No one can tell you when these will happen,” Buffett (pictured) explained. “The light can at any time go from green to red without pausing at yellow. 
“There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary.”
However, Buffett said these examples of “price randomness” in the short term can obscure the long-term benefits of stock market investing and the enormous growth that can be achieved by reinvesting earnings and allowing compound interest “to work its magic”.
To emphasise this point, he highlighted the outcome of a famous bet he made a decade ago and which he finally collected on at the end of last year.
In 2007, Buffett wagered $500,000 with Ted Seides, co-manager of Protégé Partners, that the S&P 500 would outperform a portfolio of funds of hedge funds – net of fees, costs and expenses – over 10 years.
In the end, the result was unanimous – the S&P 500 beat the hedge fund portfolio in nine of the 10 calendar years and by 89.5 percentage points, with a total return of 125.8 per cent.
Calendar year performance of index vs funds of hedge funds
Source: Berkshire Hathaway
However, Buffett said that an unintended outcome of the bet, concerned with how the managers planned to fund the prize, could teach investors an important lesson.
“Originally, Protégé and I each funded our portion of the ultimate $1m prize by purchasing $500,000 face amount of zero-coupon US Treasury bonds,” he explained.
“These bonds cost each of us $318,250 – a bit less than 64 cents on the dollar – with the $500,000 payable in 10 years.
“As the name implies, the bonds we acquired paid no interest, but – because of the discount at which they were purchased – delivered a 4.56 per cent annual return if held to maturity. Protégé and I originally intended to do no more than tally the annual returns and distribute $1m to the winning charity when the bonds matured late in 2017.
However, Buffett said that after their purchase, some “very strange things” took place in the bond market.
By November 2012, the bonds – now with about five years to go before they matured – were selling for 95.7 per cent of their face value. At that price, their annual yield to maturity stood at just 0.88 per cent.
“Given that pathetic return, our bonds had become a dumb – a really dumb – investment compared with American equities,” Buffett continued. “Over time, the S&P 500 – which mirrors a huge cross-section of American business, appropriately weighted by market value – has earned far more than 10 per cent annually on shareholders’ equity (net worth).
“In November 2012, as we were considering all this, the cash return from dividends on the S&P 500 was 2.5 per cent annually, about triple the yield on our US Treasury bond. These dividend payments were almost certain to grow.
“Beyond that, huge sums were being retained by the companies comprising the S&P 500. These businesses would use their retained earnings to expand their operations and, frequently, to repurchase their shares as well.
“Either course would, over time, substantially increase earnings-per-share. And – as has been the case since 1776 – whatever its problems of the minute, the American economy was going to move forward.”
Buffett said that presented with the extraordinary valuation mismatch between bonds and equities in late 2012, he and Protégé agreed to sell the bonds they had bought five years earlier and use the proceeds to buy 11,200 Berkshire “B” shares.
The result was that Girls Inc. of Omaha – the charity to which Buffett had pledged any prize money from the bet – found itself receiving $2,222,279 last month rather than the $1m it had originally hoped for.
Buffett pointed out that while Berkshire hasn’t performed brilliantly since the 2012 substitution, it didn’t need to – its gain only had to beat “that annual 0.88 per cent bond bogey – hardly a Herculean achievement”.
“Investing is an activity in which consumption today is foregone in an attempt to allow greater consumption at a later date,” he continued.
“‘Risk’ is the possibility that this objective won’t be attained.
“By that standard, purportedly ‘risk-free’ long-term bonds in 2012 were a far riskier investment than a long-term investment in common stocks. At that time, even a 1 per cent annual rate of inflation between 2012 and 2017 would have decreased the purchasing-power of the government bond that Protégé and I sold.”
Buffett acknowledged that in any upcoming day, week or even year, stocks will be far riskier than short-term US bonds. But as an investor’s horizon lengthens, a diversified portfolio of US equities becomes progressively less risky, assuming that the stocks are purchased at a sensible multiple of earnings relative to then-prevailing interest rates.
“It is a terrible mistake for investors with long-term horizons – among them, pension funds, college endowments and savings-minded individuals – to measure their investment ‘risk’ by their portfolio’s ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk,” he finished.