I eagerly await the pearls of investing wisdom in Warren Buffett's annual letter to Berkshire Hathaway Inc. shareholders. His 2011 missive did not disappoint.
Berkshire defines investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power (after taxes) in the future. In other words, investing is forgoing consumption now in order to have the ability to consume more at a later date.
An important corollary flows from that definition: The risk of an investment is NOT measured by the volatility of the market’s pricing, but rather by the probability of that investment’s causing its owner a loss of future purchasing power.So investments can fluctuate in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over time. Conversely, investments that don’t fluctuate much in price can be laden with risk.
In his letter, Buffett described three major categories of investments:
• “Currency-based” assets such as bonds are thought by most to be safe. They promise to pay interest regularly and return your principal at maturity. But Buffett argues that these are among the most dangerous of investments.
Why? The purchasing power of the U.S. dollar has fallen 86 percent since he took over management of Berkshire in 1965. It takes $7 today to buy what $1 did then. According to Buffett, current rates do not come close to offsetting the purchasing-power risk that investors assume.
• “Non-productive” assets such as gold require an ever-expanding pool of buyers. Buffett said gold buyers bet correctly over the past decade that the ranks of the fearful would grow, driving up prices.
Buffett pointed out that “bandwagon” investors joining any party can create their own truth—for a while. He cited Internet stocks and housing as investment bubbles that expanded when an “initially sensible thesis” combined with well-publicized rising prices to create a buying frenzy. Alas, bubbles inevitably pop, thus confirming the proverb: “What the wise man does in the beginning, the fool does in the end.”
• To no surprise, Buffet favors investing in “productive” assets such as businesses (stocks), farms or real estate. Why? “Our country’s businesses will continue to efficiently deliver goods and services wanted by our citizens.
“Metaphorically, these commercial ‘cows’ will live for centuries and give ever greater quantities of ‘milk’ ... . Their value will be determined not by the medium of exchange but rather their capacity to deliver milk. Proceeds from the sale of the milk will compound for the owners of the cows, just as they did during the 20th century when the Dow increased from 66 to 11,497 (and paid loads of dividends as well).”
You couldn’t give away 10-year U.S. Treasury bonds when they yielded 15.84 percent at the end of September 1981. Similarly, investors shunned stocks when the Dow reached 6,547 in early March 2009. As Buffett put it, in both cases, “investors who required a supportive crowd paid dearly for that comfort.”
During recent fearful times, the crowd sought comfort in “currency-based” and “non-productive” assets. Thus far, they have been rewarded with higher prices. However, Buffett thinks this comfort will once again come at a high price.
“I believe that over any extended period of time, this category of investing (i.e. “productive” assets) will be the runaway winner among the three we’ve examined. More important, it will be by far the safest.”•
Kim is the chief operating officer and chief compliance officer for Kirr Marbach & Co. LLC, an investment adviser based in Columbus, Ind. He can be reached at (812) 376-9444 or firstname.lastname@example.org.