What Warren Buffett’s Will Can Teach You

On a recent CNBC appearance, Warren Buffett discussed the investment strategy for his will:

“Well, I didn’t lay out my whole will. . . . I did explain, because I laid out what I thought the average person who is not an expert on stocks should do. And my widow will not be an expert on stocks. And I wanna be sure she gets a decent result. She isn’t gonna get a sensational result, you know? And since all  my Berkshire shares are going to philanthropy, the question becomes what does she do with the cash that’s left to her? Part of it goes outright, part of it goes to a trustee. But I’ve told the trustee to put 90% of it in an S&P 500 index fund and 10% in short-term governments. And the reason for the 10% in short-term governments is that if there’s a terrible period in the market and she’s withdrawing 3% or 4% a year you take it out of that instead of selling stocks at the wrong time. She’ll do fine with that. And anybody will do fine with that. It’s low-cost, it’s in a bunch of wonderful businesses, and it takes care of itself.”

You know what’s so great about this?

Buffett possesses the wisdom to avoid “the anchoring effect” that plagues a lot of people that aren’t on guard to avoid it. A lot of times, people who build wealth are interested in the process itself just as much (or more so) than the riches that result from it. When you make a bequest, though, you are switching to dealing with people who are far interested in the proceeds than the process. Someone who starts with a bank account balance of $0 and builds up a $5 million over the course of his lifetime probably has a heck of a life story to tell you about how he did it. Someone who inherits that $5 million is probably going to be much more interested in spending that $5 million rather than intensively focusing on the process and studying just how that wealth got created in the first place.

The person who builds the $5 million fortunate will think “I own that storage unit,” “I own those 5,000 shares of General Electric”, “I own that $150,000 rental house that pays me $1,000 per month in rent.” The person on the inheriting is more likely to see the $5 million as a giant blob of money that seems to be magically producing $250,000 each year for your bank account before you even touch the principal. This is why it is a common occurrence for inheritances to get blown. The person inheriting the money doesn’t have the same skill set and psychological profile as the one that created the money, and we shouldn’t be surprised when it leads to wealth destruction.

The other thing that Buffett’s will seems to understand very well is the notion of “horizontal risk.” That’s just jargon for being able to diversify a portfolio without sacrificing anything in the way of total returns. The person’s whose entire fortune consists of a giant block of Pepsi stock probably isn’t going to get superior returns compared to someone who owns, say, Colgate-Palmolive, Exxon Mobil, Coca-Cola, Nestle, and Johnson & Johnson. The failure risk with the Pepsi stock is that people could stop drinking its carbonated beverages and snacks (a very low probability), but the failure risk with the second portfolio is that people would need to stop brushing their teeth, fueling their car, drinking soda, eating cookies, and taking Tylenol (an extraordinarily low probability).

It was a common story in 2008 to hear stories about children that inherited million-dollar estates worth of General Motors stock, with the instruction from the father to never sell the stock. Psychologically, that creates a heck of a barrier that impedes rationality. How do you deal with making an intelligent decision about selling the stock if you grew up with your dad talking about life at the GM factory, all your cars have been GM, and it is the economic engine that allowed him to build a small fortune in life that he is passing on to you?

The fall of Enron Corporation focused attention on the potentially devastating effect of owning too much company stock. 57.73 percent of employees’ 401(k) assets were invested in Enron stock as it fell 98.8 percent in value during 2001. But employees at many companies still have even larger percentages of their 401(k) assets in company stock than Enron employees did.

The data that Finra cites says that one in ten investors have over 90% of their wealth in the stock of the company for which they currently work. Yeah, if you do that with Nestle or Colgate-Palmolive, it’s probably going to work out all right. But why take on the company-specific wipeout risk if you can build a collection of assets that will perform just as well and protects you from that 100% loss in a worst-case scenario?

By putting a large of his will in the S&P 500, Buffett seems to be following the advice of his partner Charlie Munger who is famous for saying, “You only have to get rich once.” Once we’re talking millions of dollars, the game should be over. The question “How do I protect what I got?” should start to eclipse “How can I double my money within four years?” Fortunes that ride on the success of a single stock get destroyed all the time, but wealth that hinges on the general earnings per share growth of corporate America is going to keep the mortgage paid and the lights on.

If I were writing a textbook on leaving assets to people without a passion or skill set for investing, I probably wouldn’t follow Buffett’s 90/10 split between the S&P 500 Index and short-term bonds. I’d probably do something like: 50% in the Total Stock Market Index (because it more adequately represents “the market” than the S&P 500), 10% in an International Stock Market Index, 10% in real estate (because it generally provides higher current income), and 30% in medium-term bonds (because over the long run, interest rate payouts will be higher than they are now).

In Buffett’s case, there is no real need for current income. A $100,000,000 in the S&P 500 yielding 2% still gives you $167,000 per month in profits hitting your account. That’s why Buffett’s will doesn’t need much of a bond allocation or a real estate allocation at all. The international stock market index is more a matter of personal style; half the profits from the S&P 500 come from outside the United States anyway, making it somewhat of a moot point.

Buffett’s discussion of his will gives the rest of the investing public a chance to re-examine themselves a bit. Is your fortune needlessly hitched to the success of one or two stocks? If so, the answer isn’t necessarily to sell the stock. It could simply be a “light bulb” moment that leads you to invest future cash outlays elsewhere and take the dividends (if any) from the investment and put them elsewhere. Also, Buffett provides us with a reminder to remember that you shouldn’t assume that those receiving fortunes have the same passions and skill sets as the ones creating them. Things like the S&P 500 Index Fund and Vanguard’s Wellington Fund are great tools for taking care of people you love who will simply see it as “money” without much regard for what drives the creation of wealth in the first place.


Originally posted 2014-04-09 06:00:21.

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3 thoughts on “What Warren Buffett’s Will Can Teach You

  1. innerscorecard says:

    I have been thinking more about the dividend growth v. index fund debate. I think it is hard to argue that with most people’s lack of financial knowledge and even interest, low-cost index funds invested in regularly with discipline will provide the best possible realistic returns.

    …but it is like saying that everyone who goes to the casino should just play blackjack with perfect basic strategy. The concept of indexing is so abstract, especially compared to how tangible dividend growth investing is, that I feel dividend growth investing may be superior for how many people behave. And of course, if you are willing to do financial analysis, it is plausible that it will beat the market (and of course give a smoother ride).

    I think there is an interest story in the intersection of dividend growth investing and behavioral finance. You (and other blogger peers) touch on it sometimes, with writing on the mechanics of DRIPs and Computershare and having old-fashioned stock certificates and the like. Increasing the friction and keeping Mr. Market out of things. Getting ride of the impact of the daily market quotes, which as Buffett has said, should be a blessing but turn out to be a curse.

  2. scchan_2009 says:

    I also personally like index funds. I recently read a commentary on Financial Times about the components of indices: if one track the index, you get good returns; but if you own specific components of the index, and just hold … depending on which company it is, the results can be laughable if not wiped out. The reason is that only a fraction of the companies in the markets have survived the test of time (hence Tim’s comment why Coke, Pepsi, P&G can stand the test of time, but the others, frankly speaking, just don’t). 
    Only 1/3 of the members of DJIA have survived being in the index for for more than 30 years (PG, Coke, 3M, UTX, Visa, Du Point, Exxon-Mobil, IBM, GE and Merck). Don’t laugh, even Disney, Boeing, and Pfizer aren’t all that long on the Dow!

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