Why volatility is an investor’s best friend and top insights from Warren Buffett’s 2017 letter

As Warren Buffett releases his annual Letter to Shareholders, it is an opportune moment to reflect on the recent volatility in the stock markets and lessons in the letter. The 2017 letter* to Berkshire Hathaway Shareholders has been highly anticipated and is guaranteed to contain gems of investing advice. 2018 has started off with an effective reminder of what it takes to invest in stocks, after a prolonged period of calm in the markets.

A strong start was followed by sudden drops in prices. Hopefully, this will cause investors to assess their own risk tolerance and adjust their asset allocations to suit.

Market Volatility

As for me, such volatility is expected; as I have witnessed many up and down market swings in nearly a decade of investing. From experience, the past few weeks should be seen as a time to buy more rather than sell stocks. In the long term, the market has always gone up which is why it is recommended to invest for at least a five year period. In future when we look back to now, we will wonder what all the fuss and panic was about.

A visualisation of the level of volatility afflicting the markets can be obtained by analysing the CBOE Volatility Index or the VIX for the past year:

VIX Volatility index (24 February 2018)

VIX Volatility index (1 Year to 24 February 2018)

There is a clear spike in volatility on February 5th 2018 and if you look at stock market charts you will observe that this is about where prices were near the half way point to the recent trough. As markets have recovered gradually, recent volatility has also reduced.

In hindsight it is always easy to say that we should have invested more on a particular date but the fact is that no-one can predict what the market will do next. As Jack Bogle, founder of the Vanguard Group stated, he doesn’t know anyone who knows anyone who can predict how stocks will perform. Best advice is to apply pound or dollar cost averaging, by buying stocks (low cost index funds) at regular intervals in-order to capture a range of stock prices over the long term and never sell when the market drops.

It never ceases to amaze how panicked investors or fund managers are quick to sell at the smallest signs of volatility and move money to gold, cryptos or other esoteric vehicles. Before you know it, they will be back piling into stocks when prices start rising. By then they would have missed out on gains forever and incurred multiple transaction costs.

Lessons from the 2017 Warren Buffet Letter to Berkshire Shareholders

Here are the top lessons from the latest letter to Berkshire Hathaway Shareholders.

Consistent development of portfolio

Beginning on page 4, Buffett outlines the four different ways in which value is added to Berkshire and then elaborates on a couple of the methods: making sizeable stand-alone acquisitions and the carrying out of bolt-on acquisitions to fit existing businesses.

Buffet explains that it was difficult to come across large businesses to purchase at sensible prices in 2017 and why it is not a good idea to use leverage/ debt when making investment purchases. However, a single sensible purchase was made of the truck stop company Pilot Flying J. A number of smaller bolt on acquisitions were also carried out.

To me, the advice is that you should stick to long term simple investment principles, avoid debt and constantly work on your investment portfolio, aiming to increase future returns by adding value in the present, brick by brick.

The Importance of holding emergency funds

On page 7, Buffett stresses the importance and purpose of holding treasury bills. Holding substantial amounts of these bills prevented Berkshire from relying on the kindness of others or short term lending such as commercial paper or bank lines during the 2008-2009 financial crisis.

On a personal level, investors can apply this approach by holding a good amount of government/ treasury bonds within their portfolio as part of the asset allocation. Also essential is to have a reasonable cash emergency fund which can withstand even extreme circumstances.

Holding too much cash is not ideal

A lot of people think that investing in stocks is very risky and therefore tend to hold the majority of their funds in cash or perceived assets such as real estate. However, returns on cash are minimal or negative when inflation is considered and over the long term, stocks have achieved decent returns in comparison to other asset classes.

Berkshire Hathaway currently holds $116 Billion in cash and treasury bills. Buffett notes that this extraordinary amount only earns a pittance and is far more than he and partner Charlie Munger wish to have. They would rather deploy some of the cash to make one or more large acquisitions which would substantially increase income from non insurance sources. The lesson is to look at your entire portfolio and ensure that it is optimised to obtain the best possible returns while also maintaining a margin of safety.

View stock market holdings as real businesses

Buffet’s quote says it all (page 10):

“Charlie and I view the marketable common stocks that Berkshire owns as interests in businesses, not as ticker symbols to be bought or sold based on their “chart” patterns, the “target” prices of analysts or the opinions of media pundits. Instead, we simply believe that if the businesses of the investees are successful (as we believe most will be) our investments will be successful as well. Sometimes the payoffs to us will be modest; occasionally the cash register will ring loudly. And sometimes I will make expensive mistakes. Overall – and over time – we should get decent results. In America, equity investors have the wind at their back.”

Other lessons

In the letter there is an update on the bet, where the S&P 500 index, backed by Buffett beat a selection of expensive actively management funds selected by hedge fund managers over a ten year period, proving the benefits of low cost index funds.

Also noted is that with time stocks will progressively become a less risky investment than bonds; meaning that risk should not be measured by a portfolio’s asset allocation ratio. Bonds or cash should not be considered as “risk free”.

The final lesson is for the long term investor to avoid thinking too hard about investing, trying to be intelligent or always take action, but to make few big “easy” decisions while reducing activity. An MBA, high IQ, working in Wall Street, analysing charts or knowledge of financial jargon are not needed here.

*The 2017 annual letter Shareholders of Berkshire Hathaway Inc. (24 Feb. 2018 by Warren E. Buffett Chairman of the Board) be accessed in pdf form here.

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