Stock markets have delivered better returns than cash and other assets over the long term. And the beauty is that anyone can enjoy the wealth benefit of investing in shares. Whatever your knowledge, octogenarian billionaire investor Warren Buffett has a strategy for you.
The money-making market
Most people lack the time and/or interest to study individual companies. But that doesn’t mean they can’t enjoy the fruits of stock market returns. In his will, Buffett provides a trust for his wife:
“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”.
Index funds, or “trackers” simply track a stock market index, such as the USA’s S&P 500 or the UK’s FTSE All-Share. Trackers give investors the return of the index — less charges, which is why Buffett emphasises going for a “very low-cost” provider, such as Vanguard.
Buffett has some valuable additional advice for new investors:
“The main danger is that the timid or beginning investor will enter the market at a time of extreme exuberance and then become disillusioned when paper losses occur … The antidote to that kind of mistiming is for an investor to accumulate shares over a long period and never to sell when the news is bad and stocks are well off their highs”.
Beating the market with blue chips
If you have the time and interest to study individual companies, you can hope to achieve a better return than a tracker by investing in more of the index’s star performers and fewer of the duds. This, of course, is what Buffett has done — decade after decade.
Buffett selects companies with a durable competitive advantage, or, as he puts it, “economic castles protected by unbreachable ‘moats'”. And he advises: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”.
You can get an idea of what Buffett means by a wonderful company from looking at the holdings of his Berkshire Hathaway investment group. Here you’ll find such blue-chip luminaries as Wells Fargo, American Express, Coca-Cola and IBM.
To identify wonderful companies and judge when their shares are trading at a fair price, you’ll need to put in the time and effort to understand profit margins, return on equity and other business “fundamentals”. The rewards, though, can be great.
Super-size returns from small caps
These days, because Buffett is managing billions of dollars, he’s largely restricted to choosing his investments from among the stock market’s biggest companies. He notes:
“It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million … But you can’t compound $100 million or $1 billion at anything remotely like that rate”.
Buffett made his highest rates of returns in the 1950s when he was investing “peanuts”. He gives us a steer on where to look if we’re shooting for the highest potential rewards: “If I had $10,000 to invest, I would focus on smaller companies, because there would be a greater chance that something was overlooked in that arena”.
While there’s more scope for smaller companies to be “mispriced”, and while their accounts are often simpler to read than those of larger companies, the businesses are typically more difficult to assess in terms of durable competitive advantage, quality of management (something Buffett puts a great deal of store in) and future cash flows.
Nevertheless, for investors who become skilled at company analysis — and who have the right temperament to cope with volatile share prices — small caps have the potential to deliver super-size returns.
