RIA Insights

Investing is like Dieting

This May, at the Berkshire Hathaway annual meeting, Warren Buffett boiled down what it means to be an intelligent investor into two startling sentences: “If a stock [I own] goes down 50%, I’d look forward to it. In fact, I would offer you a significant sum of money if you could give me the opportunity for all of my stocks to go down 50% over the next month.” Knowing he owns good businesses, Mr. Buffett wants prices to go down, not up, so he can buy even more shares more cheaply before they bounce back.

In the last long bear market, 1969 to 1982, stocks returned just 5.6% annually; after inflation, investors lost more than 2% a year. That mauling by the bear made stocks so inexpensive that over the ensuing 18 years they went up 18.5% a year, enough to turn $10,000 into more than $200,000. The renowned investor Benjamin Graham once wrote that “the investor’s chief problem — and even his worst enemy — is likely to be himself.” Equity markets are chaotic and the reason we expect the risk premium is that there are periods of extreme volatility.

For, as Mr. Buffett has also pointed out, investing is much like dieting: it is simple, but not easy. Everyone knows what it takes to lose weight. (Eat less, exercise more.) Nothing could be simpler, but few things are harder in a world full of chocolate cake and Cheetos. Likewise, investing is simple: diversify, buy and hold, rebalance and keep costs low. But simple isn’t easy in an environment that has seen extreme volatility as a result of skyrocketing oil prices, shaky lending practices and faltering investment banks. The real secret to being, or becoming, an intelligent investor is bolstering your self-control.

Nonprofits face unique challenges which greatly complicate matters.  Most long term reserves operate within an indefinite or uncertain time frame.  Furthermore, additional funds are often not available to buy additional securities as prices fall – as they are in 401k plans or other savings plans.  Accordingly, intelligent nonprofit investing must be matched with clear expectations and a thorough understanding of the organization’s cash flow requirements and tolerance for losses in the short term.  A well drafted investment policy should provide direction and minimize emotionally driven decision making.  A formal rebalancing policy should dictate the systematic process of selling high and buying lower.

Buffett’s Big Bet

Fortune senior editor Carol Loomis has had a special relationship with Berkshire Hathaway chief executive Warren Buffett for many years, both as a personal friend and as the editor of Mr. Buffett’s widely read annual letter to Berkshire stockholders. Among many contributions throughout a Fortune career spanning more than fifty years, Loomis has written numerous thought-provoking articles about Berkshire and Buffett.

Drawing on that special relationship, Loomis has revealed to Fortune readers the details of an intriguing bet placed earlier this year by Mr. Buffett that should be of interest to any investor contemplating a commitment to hedge funds.

Buffett has often warned of the potential wealth destruction associated with investment expenses. In a 1999 Fortune article, he pointed out that the long-run return to investors in corporate America cannot be higher than what corporate America earns on its assets and that efforts to earn higher returns by moving money from one business to another (“chair-changing,” in Mr. Buffett’s lingo) might be successful for some investors but can only penalize results for investors in aggregate. To illustrate this idea, Buffett suggested in Berkshire’s 2005 annual report that readers imagine a simplified world in which all American corporations are owned in perpetuity by a single family, the Gotrocks. Succumbing to the promises of various “helpers” from the financial industry, some family members attempt to outsmart their relatives by purchasing some of their shares in various businesses and selling certain others. Other “hyper-helpers” appear to assist in selecting the best helpers (for an additional fee, of course.) The net effect on the Gotrock family wealth can only be negative as the total earnings on American businesses are diminished by the helpers’ fees. Buffett argues that the total “chair-changing costs” are substantial, estimating that “the family’s frictional costs of all sorts may well amount to 20% of the earnings of American business.”

Buffett revisited the issue in Berkshire’s 2006 annual report, turning his attention to the fees charged by the typical hedge fund. Referring to the “2-and-20” crowd, Buffett observed that “the inexorable math of this grotesque arrangement is certain to make the Gotrocks family poorer over time than it would have been had it never heard of these ‘hyper-helpers.’