Warren Buffett, one of the most successful investors of all time, introduced the "90/10" investment strategy in his 2013 letter to Berkshire Hathaway shareholders. The essence of this strategy is to allocate 90% of one's investment capital to low-cost stock index funds, particularly the S&P 500, and the remaining 10% to low-risk government bonds. This approach is a departure from conventional strategies, which often recommend a lower percentage of stocks and a higher percentage of bonds as investors age.
Key Takeaways of the 90/10 Strategy
The 90/10 strategy centers on aggressive growth, suggesting that investors should place the vast majority of their funds in equities, while still maintaining a small portion in more stable, lower-risk bonds. Here's a summary of its key components:
- 90% in Equities: Specifically, low-cost S&P 500 index funds or similar ETFs which aim to mimic the performance of major corporations.
- 10% in Bonds: Generally, short-term government bonds such as Treasury bills that provide safety and liquidity.
- Endorsement from Buffett: The strategy is backed by Buffett himself, who mentioned it in the context of his own estate planning to ensure his spouse's financial security after his passing.
How the 90/10 Strategy Works
The 90/10 strategy primarily works on the principle of leveraging the long-term growth potential of equities while minimizing expenses associated with active fund management.
Warren Buffett's letter emphasized that this allocation will likely outperform most investors, particularly those relying on high-fee active managers. With the example of a $100,000 portfolio, an investor could place $90,000 in an S&P 500 index fund and $10,000 in Treasury bills. For instance, if the S&P 500 returned 10% for the year while Treasury bills returned 4%, the overall return would be calculated as follows:
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Overall Return = (0.90 x 10%) + (0.10 x 4%) = 0.094 or 9.4%
Importance of Low Investment Costs
Buffett’s advocacy for low-cost index funds is rooted in several studies that demonstrate the challenge of consistently outperforming the market by active management. Using lower-cost index funds helps investors retain more of their earnings by minimizing management fees. This can significantly compound over time, leading to higher total returns compared to actively managed funds that tend to charge higher fees.
Selection Criteria for Index Funds
When choosing a fund, investors should consider:
- Expense Ratios: Look for funds with lower operating costs.
- Performance History: While index funds usually track closely, there can be variances in performance based on fund management and fees.
- No-Load Funds: Opt for funds with no commissions to maximize the investment's potential.
The Risks and Criticism of the 90/10 Strategy
Despite its potential for higher returns, the 90/10 strategy is not without its criticisms.
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High Risk: With 90% of the portfolio in equities, this strategy can lead to significant exposure to market volatility. Market downturns can lead to considerable short-term losses, which can be psychologically taxing for investors not prepared for such fluctuations.
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Suitability: The strategy may not be appropriate for those close to retirement or those with low risk tolerance since it can lead to losses when markets fluctuate.
Experts suggest that those considering this strategy should ask themselves whether they can endure the stress of market volatility. As financial writer Walter Updegrave remarked in 2018, understanding one's emotional resilience in times of market distress is crucial for adopting such an aggressive approach.
Alternatives to the 90/10 Strategy
The traditional 60/40 portfolio—allocating 60% to stocks and 40% to bonds—serves as a more conservative alternative. This balanced approach aims to provide steady growth while mitigating risk through a more substantial bond allocation. The following points highlight differences:
- Risk and Growth: The 60/40 portfolio offers lower volatility, which is attractive to conservative investors. In contrast, the 90/10 strategy focuses on growth with higher risks.
- Market Resilience: The bond allocation in a 60/40 strategy is designed to provide a buffer in market downturns, offering a degree of capital protection.
Who Should Consider the 90/10 Strategy?
Investors best suited for the 90/10 strategy typically share the following characteristics:
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Long-Term Investment Horizon: Particularly beneficial for younger individuals who can withstand market volatility over time while aiming for growth.
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High Risk Tolerance: Ideal for those comfortable with fluctuations and who have the emotional fortitude to withstand market downturns.
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DIY Investors: Those who prefer a straightforward, hands-off investment approach will find that the 90/10 strategy is easy to maintain.
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Optimistic Outlook: Investors who have confidence in long-term market growth and economic stability may feel more inclined to adopt this strategy.
Advantages of the 90/10 Investment Allocation
The primary advantage of this allocation is the potential for significant long-term growth due to the substantial equity exposure. For younger investors or those saving for long-term goals, the rewards may outweigh the risks given ample time to recover from market volatility.
Not Suitable for Conservative Investors
For conservative investors who focus on preserving capital rather than risking it for potential returns, the 90/10 strategy may prove too volatile. A more balanced approach, such as the 60/40 model, is often touted as more appropriate for risk-averse individuals.
Rebalancing the 90/10 Portfolio
Investors should periodically rebalance their portfolio—typically on an annual basis or whenever the asset allocation deviates significantly from the target. Rebalancing involves selling assets that have increased in value and buying those that have declined to maintain a 90/10 allocation. For proactive management, investors may consider rebalancing any time the stock proportion exceeds 95% or drops below 85%.
Conclusion
The 90/10 investment strategy remains an audacious option for those willing to take on higher risk for potentially higher rewards. While Warren Buffett’s endorsement carries weight, it's essential for investors to critically evaluate their risk tolerance and investment timeline before adopting this approach. Understanding your financial goals and risk capacity should ultimately dictate the strategy you choose to pursue.