Here's Why Warren Buffett's Advice to His Heirs is Wrong

Barbara Friedberg  |

Here's Warren Buffett's advice for investing - to his heirs. It's great advice - just not for you.

Warren Buffett is arguably one of the best investors that has ever lived. His iconic Berkshire Hathaway BRK.A, currently trading at $301,160, earned an annualized return of 20.9% between 1965 and 2017. That's in contrast with the respectable 9.9% performance of the S&P 500 during that same period. (As reported in his 2017 Berkshire Hathaway annual letter to shareholders.)

So, why in the world is he advising the executors of his estate to invest 90% of the proceeds in an S&P 500 index fund, instead of his Berkshire Hathaway stock?

After all, Buffett and his partner Charlie Munger hired top-notch managers to run the company upon their deaths. Doesn't Buffett have faith in his successors? Even Munger is sticking with Berkshire Hathaway for his heirs.

Buffett clearly explains why he recommends index funds. He believes in the strength of U.S. businesses and expects them to continue to prosper. Buffett also discussed in his 2014 shareholder letter his fear that stock picking investors would shoot themselves in the foot when markets drop. (Ok, he didn't say that exactly, but, the idea was there.)

He believes that the S&P 500 includes a well-diversified group of businesses that are bound to do well over the long term.

Warren Buffett's advice is to capture the returns of these businesses by keeping fees low - thus the index fund. If companies continue to grow and prosper then the stock market performance will be good.

In fact, Buffett's opinion coincides with the bounty of research that states most investors, actively managed mutual funds and financial professionals fail to beat the S&P 500 stock market index. Recent S&P research found that between 2012 and December 29, 2017, 84.23% of large-cap funds failed to beat the returns of the S&P 500.

And that's why Warren Buffett's advice is to invest in low-fee index funds.

Don't get me wrong, I love index funds. In fact, I've gone from a stock picker to an index fund investor. So, why do I think Buffett's advice to his heirs is wrong?

Actually, it's not all wrong, just partially wrong.

First, the asset allocation of 90% stocks and 10% in short-term government bonds is too extreme.

Imagine what would happen to your portfolio should the stock market crash and drop 36.55% like it did in 2008. Or, how would you feel if the stock market dropped 21.97% like it did in 2002? Could you ride it out without selling?

With Buffett's 90%-10% stock/bond allocation, if you had a $500,000 portfolio invested 90% in an S&P 50 index fund and 10% in short-term Treasuries, your investments would be worth $411,500 after a 20% stock market drop. This assumes that Treasuries returned 3%. That's a one-year loss of $88,500 or approximately 17% for your investment portfolio.

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Warren Buffett's advice to his heirs is wrong - find out why.

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A 90% stock and 10% treasury portfolio is an extreme asset allocation for the average investor. Sure, with a 90% stock, 10% treasury allocation you would maximize your gains during well performing years, but during those occasional down stock markets, you'd experience huge losses.

Warren Buffet's widow will have more than enough money to withstand extreme stock market volatility. But most of us don't.

That's why most investment risk quizzes recommend a more moderate stock vs. bond asset allocation. Because the average investor can't sit tight and tolerate the pain of a huge stock market drop.

So, in contrast with Buffett's advice, most investors should temper their asset allocation towards a more balanced stock vs. bond allocation. If you're young and an aggressive investor, 90% stock and 10% treasuries might be ok, but for the rest, lighten up on the stock holdings and invest a bit more in the fixed investment category.

Second, you might want to broaden your stock and bond fund holdings.

The U.S. is approximately 50% of the world's stock market. And, we're a mature market with many older companies. In general, newer, smaller firms grow faster and deliver higher returns than old stalwarts. So, investors should take a look at international stock funds and possibly small-cap funds as well.

You might want to consider an international index fund with exposure to both developed and developing markets such as Vanguard's All-World ex-US ETF (VEU). This index fund has a low expense ratio of 0.11% and gives you exposure to companies around the world, many of which are growing faster than those in the U.S.

If you want to diversify further, there are countless other index fund varieties that cover various segments of the stock and bond markets, all sporting low management fees.

Now, I'm not suggesting that you buy 10 diversified low-fee index funds, but a few more than two might pump up your returns and give you a bit more diversification should the U.S. stock market fall while the rest of the world market's hold steady.

Our family invests in REIT, small cap, value and international stock index funds along with several types of bonds.

Index fund investing is clearly the best strategy for most investors. With low fees and great diversification, you'll likely beat most active fund managers, as long as you hold on for the long haul. For those without a steely stomach, tweak your asset allocation to hold 60% to 85% stock funds and the rest in bond funds.

Warren Buffett's advice is perfect for his heirs, but you might want to adjust it a smidge to fit your personal investing. And whatever you do, don't let fear cause you to jump out of the markets after a decline. You just might miss the next bull market.

DISCLOSURE: I own shares in Vanguard's All-World ex-US ETF (VEU) and Vanguards S&P 500 Index mutual and ETFs.

The views and opinions expressed in this article are those of the authors, and do not necessarily represent the views of Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to:

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