In this 3 part series, I will present my thoughts on the topic Retirement Portfolio. 

The series will cover the following topics:

1. In the first part, I will explore in some details what Warren Buffet has to say on the topic of retirement portfolio.
2. The second part of the series will explore strategies for portfolio diversification beyond the so-called Buffet Portfolio.
3. In the third part of the series, I will outline my retirement portfolio. I will also discuss some tools that I have put together to manage my retirement portfolio.

Buffet Advice

Let us begin with the following quotes from Warren Buffet on the topic of retirement planning:

“Over the years, I’ve often been asked for investment advice, and in the process of answering I’ve learned a good deal about human behavior. My regular recommendation has been a low-cost S&P 500 index fund”

“My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund.  I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions, or individuals — who employ high-fee managers.”

No fuss here. A very simple advise to construct a portfolio comprised of just 2 funds, with bulk of assets invested into a diversified S&P500 index fund.

Constructing Buffet Portfolio

How would one go about constructing the Buffet Portfolio?

For an individual investor, two choices exist:

1. the open-ended investment company, also known as mutual fund or
2. Exchange traded funds (ETFs)

There are several articles to be found online on the pros and cons of each investment vehicle for passive investments, see for example: investopedia, the balance, morningstar.

One key difference that I have noticed between these two investment vehicles and the one that is not often discussed is related to the ease of portfolio re-balancing.

Most traditional brokerage firms offer automated portfolio balancing service for portfolio’s comprised of mutual funds, which is not the case with portfolio comprised of ETF’s.

For me, the convenience of being able to trade in and out “at will” and low-cost relative to the open-ended fund counterpart trumps the inconvenience of manual rebalancing. My choice for portfolio construction is therefore heavily biased towards the use of ETFs.

Below is the summary of ETFs that track the S&P500 index

	SPDR S&P 500 ETF	IShares Core S&P 500 ETF	Vanguard S&P 500 ETF
Ticket Symbol	SPY	IVV	VOO
Net Expense Ratio	0.0945 %	0.04 %	0.04 %
Tracking Error	0.03	0.04	0.03
Total Asset	$237,640,705	$120,526,072	$70,308,744
Inception Date	01/22/1993	05/15/2000	09/07/2010
Commission Free Trade		TD Ameritrade, Fidelity	Vanguard

SPY is the oldest of the S&P 500 ETFs with highest amount of dollar-funds under management. Vanguard’s offering is the newest on the block, with extremely low expense ratio and tracking error.

A dollar invested in any one of the 3 ETFs listed above on the first day of the offering of Vanguard fund would have more than doubled in the last seven years, as can be seen from the chart below. Also, since each of the 3 ETFs track the same underlying index fund, they are pretty indistinguishable in terms of their long-term performance.

The choice of which ETF to pick in this category to include in the construction of Buffet-Portfolio therefore boils down to the brokerage firm used for holding the portfolio so as to minimize the transaction cost.

As to the suggestion for short-term govt bond, Buffet’s advise lacks some precision. For example, it is not clear from Buffet’s statement, whether short-term refers to 1-3 months or 1-3 years. Clearly, depending on the duration, the investment vehicle will change and so will the risk profile and the interest rates on the underlying bond-asset.

I would venture to interpret Buffet’s suggestion for short-term to mean 1-3 year US-Treasury bond, based on the idea that very short-term, i.e., 1-3 month bonds are almost equivalent to cash holdings in the portfolio, offering almost zero return-on-investments.

Below are ETFs vehicles for investing in the short-term 1-3 year US-Govt Bonds.

	iShares 1-3 Yr Treasury Bond ETF	Schwab Short-Term Treasury ETF	Vanguard Short-Term Gov. Bond ETF	PIMCO 1-3 Year US Treasury Index Fund
Ticket Symbol	SHY	SCHO	VGSH	TUZ
Index Tracked	ICE US Treasury 1-3 Year Index	Bloomberg Barclays US 1-3 Year Treasure Bond Index	Bloomberg Barclays US 1-3 Year Float Adjusted Index	BofA Merrill Lynch 1-3 Yr Treasury Index
Net Expense Ratio	0.15 %	0.06 %	0.07 %	0.15 %
Tracking Error	0.03	0.04	0.06	0.05
Total Asset	$10.99 B	$1.87 B	$1.82 B	$119.38 M
Inception Date	07/22/2002	08/05/2010	11/19/2009	06/01/2009
Commission Free Trade	Fidelity, TD Ameritrade		Vanguard

SHY is the oldest of the bunch with highest assets under management. SCHO being the newest of the bunch but is quickly becoming quite a prominent fund in this category due to its low expense-ratio and low tracking error.

Also looking at the chart below, one cannot help but notice a high degree of variability in returns of the 1-3 Yr Treasure Bond funds. If I have to venture a guess, the cause may be related to the lack of a universal benchmark index that each of theses ETFs follow.

Based on the choices available and taking into account the transaction costs, one possible choice for a low-cost passive strategy of retirement investment with Buffet Portfolio would be:

90 % IVV, 10 % SCHO portfolio created either at Fidelity or TD-Ameritrade.

Buffet Portfolio-Performance

In 2004 annual Berkshire meeting, Buffet said:

“Among the various propositions offered to you, if you invested in a very low-cost index fund — where you don’t put the money in at one time, but average in over 10 years — you’ll do better than 90% of people who start investing at the same time.”

Buffet Portfolio constructed with an initial investment of $10000 and annual rebalanced, would have grown to $20644 today, producing a healthy  annual rate of return of about 5.7 %, especially considering the fact that time period includes the financial turmoil of 2007-2008.

The charts below track the evolution of Buffet-Portfolio over this time-period. Column 1 show the growth of total assets in the portfolio. Columns 2 and 3 track the change in number of each equity asset in the portfolio, resulting from annual portfolio re-balancing.

Is Buffet Portfolio Diversified Enough

It is quite evident that Buffet Portfolio is primarily a bet on America and is in line with Buffet’s thinking on the topic, see for example Buffet quote circa 2015:

“America’s economic magic remains alive and well”

Bloomberg has an entire article devoted Buffet quotes over the years on the American Dream.

Since the financial melt-down, adhering to this philosophy has been quite beneficial to every investor who has fully participated in the American markets.  It is therefore quite tempting to adhere to Buffet advise and simply index all of our equity diversification to S&P 500. 

However, given the premise of this blog and I believe, the desire of all retirement investors for captical compounding for the long haul, we should be vary of the possibility for a correction in US equity markets. And if the correction indeed happens, we could be in for a ride with Buffet Portfolio.

Let us look into some data that may offer some insights into where we are in the market-cycle in relation to US equity markets.

Buffet Indicator

In a 2001 Fortune magazine interview, Buffet opined on the macro state of the economy by stating that Buffet ratio, which he defined as the market value of all publicly traded securities as a percent of country’s GDP  “is probably the best single measure of where valuations stand at any given moment“.

In chart below (from Advisor Perspectives), we show where the Buffet indicator as it stands today.

The all time high for Buffet-indicator was reached at the peak of dot-com bubble.

Shiller PE Ratio for S&P 500 Index

The chart below, shows Shiller’s PE ratio for S&P 500 index (from multpl.com)

Shiller PE ratio is the ratio of price to average inflation adjusted earnings over last 10 years for all S&P 500 listed stocks.

It is interesting to note that Shiller PE is quite close to what it was at the peak of the most devastating stock market crash of 1929. The only other time when Shiller PE has grown beyond 30 is during the dot-com bubble.

Historical average for Shiller PE is 15.66. We are today at PE of almost twice that of historical averages.

Sound Bytes

Grantham, Mayo, Van Otterloo & Co. LLC  a global investment firm has recently put out a white paper titled: The S&P 500: Just Say No.

The primary thesis of the article is that the expected growth in earning and dividends for US equities do not justify the current hefty valuation of S&P 500 index and that better opportunities currently lie in the emerging markets.

Howard Marks, the legendary fund manager and Co. Chairman of Oaktree Capital put out a memo recently, titled There They Go Again… Again.

While summarizing all the things that Howard Marks has discussed in the article, is worthy of a blog in itself, one particular quote from the memo quite succinctly summarizes (to my  mind) the euphoria surrounding the present bull-markets:

“Where are we today? As I said earlier, risk is high and prospective return is low, and the low
prospective returns on safe investments are pushing people into taking risk – which they’re
willing to do – at a time when the reward for doing so is low.”

Summary

While I am not 100% certain that following Buffet’s advise to stay diversified only in the US markets is a great advise for one’s retirement portfolio, I want to leave you with the following tips from Buffet that are quite useful towards the goal of growing and preserving wealth over a long haul:

1. Keep it simple
2. Start early
3. Don’t try to time the markets
4. Don’t be afraid to buy the dips

Notes

1. Github resource to download investmenttools package: investmenttools
2. IPython notebook example to reproduce the Buffet-Portfolio plots: Buffet_Portfolio.html