The Time Warren Buffett Got It Wrong

Summary

• Warren Buffett has suggested that a retiree might hold a mix of 90% equities and 10% bonds.
• The all-stock portfolio actually works quite well funding 4% or more of portfolio value, inflation adjusted, over most 30 year periods.
• But the equity portfolio increases risk during years of successive market declines.
• We'll have a look at the 90/10 portfolio for retirees, a 60/40 mix, along with bucketing with cash and bonds to fund retirement in stages.

In a previous article I explored Warren Buffett's suggestion that retirees hold a portfolio that consists of 90% stocks (SPY) and 10% bonds. From Warren...

My advice to the trustee couldn't 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 suggest Vanguard's.) 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.

Being one of the only investors on the planet still a believer in the importance of bonds, that one was a head-scratcher for me. But I had to investigate the world's most successful investor's recommendation, after all he is the world's most successful investor in the accumulation phase. Is Warren spot on when it comes to the spending stage? I started by having a look at an all-equity portfolio in the spending stage.

Running the numbers showed that an all S&P 500 portfolio delivered a very high probability that it could provide a 4% plus annual income with an inflation adjustment. In fact, according to the Monte Carlo tool on moneychimp.com an all-equity portfolio had an impressive 95% success rate delivering income for 30 year spans. That's nothing but incredible. An all-stock portfolio in the inflation adjusted (2%) draw down phase over the last ten years would have increased in value.

Year	Starting Balance	Income	Remaining Balance	Total Return	Balance
2004	1,000,000	$40,000	960,000	10.7%	1,062,720
2005	1,062,720	$40,800	1,021,920	4.8%	1,070,972
2006	1,070,972	$41,616	1,029,356	15.9%	1,193,023
2007	1,193,023	$42,448	1,150,575	5.2%	1,210,404
2008	1,210,404	$43,296	1,167,108	-36.8%	737,612
2009	737,612	$44,162	693,450	26.3%	875,827
2010	875,827	$45,045	830,782	15.1%	956,230
2011	956,230	$45,946	910,284	1.9%	927,579
2012	927,579	$46,864	880,715	16%	1,021,629
2013	1,021,629	$47,802	973,827	32.2%	1,287,339

Click to enlarge

The above scenario worked out quite well due to the fact that the start date delivered four years of positive equity returns. The portfolio had a great head start heading into the great recession, and the incredible bull run of the last 5 years allowed the portfolio to recover in full from 2007. The all-equity portfolio could even survive a horrible start date of 2008, but it's a different story if an investor has the unfortunate situation of starting their retirement in a period of successive stock market declines. The year 2000 start date delivered 3 down years, a very rare occurrence as we'd have to go back to the Depression to find that same scenario. But anything and everything is possible, and an investor should protect against the hazards.

Year	Starting Balance	Income	Total Return	Balance
2000	1,000,000	$40,000	-9.03%	873,312
2001	873,312	$40,800	-11.85%	733,859
2002	733,859	$41,616	-21.97%	540,157
2003	540,157	$42,448	28.36%	638,859
2004	638,859	$43,296	10.74%	659,526
2005	659,526	$44,161	4.83%	645,088
2006	645,088	$45,044	15.61%	693,711
2007	693,711	$45,945	5.48%	683,264
2008	683,264	$46,869	-36.8%	402,201
2009	402,201	$47,801	26.3%	447,607
2010	447,607	$48,757	15.1%	459,076
2011	459,076	$49,732	1.9%	417,121
2012	417,121	$50,726	16%	425,018
2013	425,018	$51,740	32.2%	493,473

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The year 2000 start date decimated most equity-heavy retirement portfolios. As we can see the above portfolio stands little chance of providing income for a 25-year period. The next stock market correction combined with increasing income needs of the retiree is a one-two punch that will leave this portfolio on the mat with the referee counting to ten. The equity portfolio will not likely survive.

So what about Warren's suggestion that a retiree hold 10% bonds? Will that provide the insurance necessary? As I stated in the previous article, bonds did their thing from 2000; when the stock markets were sinking the bonds were sailing. But is 10% enough? For this demonstration I used 10-year Treasuries on a total return basis.

Year	Starting Balance	Income	Total Return	Balance
2000
Stock	900,000	36,000	-9.03%	785,981
Bonds	100,000	4,000	16.6%	111,936
Total				897,917
2001	785,981	36,720	-11.85%	660,474
Bonds	111,936	4,080	5.57%	113,863
Total				774,337
2002	696,899	37,454	-21.97%	515,224
Bonds	77,438	4,161	15.12%	84,356
Total				599,580
2003	539,622	38,203	28.36%	643,621
Bonds	59,958	4,245	00.38%	55,925
Total				699,546
2004	629,591	38,966	10.74%	654,058
Bonds	69,955	4,329	4.49%	68,573
Total				722,630
2005	654,058	39,744	4.83%	643,985
Bonds	68,573	4,416	2.87%	65,998
Total				709,983
2006	643,985	40,539	15.61%	697,644
Bonds	65,998	4,504	1.96%	62,699
Total				760,343
2007	697,644	41,350	5.48%	692,259
Bonds	62,699	4,595	10.21%	64,036
Total				756,295
2008	692,259	42,182	-36.8%	410,848
Bonds	64,036	4,687	20.1%	71,287
Total				482,135
2009	433,922	43,020	26.3%	493,709
Bonds	48,213	4,780	-11.12%	38,603
Total				532,312
2010	479,081	43,881	15.1%	500,915
Bonds	53,231	4,876	8.46%	52,446
Total				553,360
2011	500,915	44,759	1.9%	464,823
Bonds	52,446	4,973	16.04%	55,088
Total				519,911
2012	467,920	45,653	16%	489,829
Bonds	51,991	5,073	2.97%	48,311
Total				538,140
2013	489,829	46,566	32.2%	585,993
Bonds	48,311	5,174	-9.1%	39,212
Total				625,205

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That 10% bond allocation simply came up short. It saved the investor over $125,000 in losses, but that $625k portfolio value is limping with little chance of survival. Like the wounded brave knight in Monty Python's Holy Grail it might declare "I'm not dead yet," but it is certainly more than a flesh wound. An investor holding that portfolio would be best served by giving up some "lifestyle" and dropping the income demands from over $51,000 back to the 4-5% of portfolio value which would bring the total income drawn to the $30,000 area.

BUCKETING

Another popular style of retirement planning is creating buckets that would fund the retirement in stages. The cash would cover the first two years, the bonds would cover the next two or three and the equities can cover the longer-term needs. So what happens when we still use Warren's 90/10 portfolio but with 2 years' worth of cash? The portfolio is rebalanced after the initial 2 year period.

Year	Starting Balance	Income	Total Return	Balance
2000
Stock	827,280		-9.03%	752,576
Cash	80,800	40,000		40,800
Bonds	91,920		16.6%	107,178
Total				900,554
2001
Stock	752,576	0	-11.85%	663,395
Cash	44,000	40,800		0
Bonds	107,178		5.57%	113,147
Total				776,542
2002
Stock	698,887	37,454	-21.97%	516,116
Bonds	77,654	4,161	15.12%	84,605
Total				600,721
2003	540,648	38,203	28.36%	644,938
Bonds	60,072	4,245	00.38%	56,039
Total				700,977
2004	630,879	38,966	10.74%	655,484
Bonds	70,097	4,329	4.49%	68,720
Total				724,204
2005	651,784	39,744	4.83%	641,601
Bonds	72,420	4,416	2.87%	69,770
Total				711,371
2006	640,234	40,539	15.61%	693,307
Bonds	71,137	4,504	1.96%	67,969
Total				761,246
2007	685,121	41,350	5.48%	679,049
Bonds	76,124	4,595	10.21%	78,832
Total				757,881
2008	682,092	42,182	-36.8%	404,423
Bonds	75,788	4,687	20.1%	85,392
Total				489,815
2009	440,833	43,020	26.3%	502,437
Bonds	48,981	4,780	-11.12%	39,285
Total				541,722
2010	487549	43,881	15.1%	510,661
Bonds	54172	4,876	8.46%	53,466
Total				564,127
2011	592,836	44,759	1.9%	558,490
Bonds	78,056	4,973	16.04%	84,805
Total				643,295
2012	578,966	45,653	16%	618,643
Bonds	64,329	5,073	2.97%	61,016
Total				679,659
2013	618,643	46,566	32.2%	756,285
Bonds	61,016	5,174	-9.1%	50,760
Total				807,045

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Well that gives the portfolio a fighting chance. It's wounded most certainly, but the portfolio would likely be able to deliver decent income for many years to follow. In the above approach, an investor could have followed stage 2 of bucketing and used the bond component (entirely) to fund year 3, meaning there would have been no selling of stocks in the down years.

It once again might be advisable for the retiree to adjust their spending plans modestly.

So being a balanced investor (I'm talking numerically here, only) I had to have a look at what happens when we use the traditional 60% stock and 40% bond portfolio. We know that mix works incredibly well in the accumulation phase, but what about in retirement? The portfolio is rebalanced annually.

Year	Starting Balance	Income	Total Return	Balance
2000
Stock	600,000	24,000	-9.03%	523,987
Bonds	400,000	16,000	16.6%	447,744
Total				971,731
2001	583,038	24,480	-11.85%	483,205
Bonds	388,692	16,320	5.57%	393,113
Total				876,319
2002	525,791	24,969	-21.97%	390,791
Bonds	350,527	16,646	15.12%	384,363
Total				775,154
2003	465,092	25,468	28.36%	564,301
Bonds	310,061	16,978	00.38%	294,196
Total				858,497
2004	515,098	25,977	10.74%	541,652
Bonds	343,398	17,317	4.49%	340,722
Total				882,374
2005	529,424	26,496	4.83%	527,219
Bonds	352,949	17,663	2.87%	344,908
Total				872,127
2006	523,276	26,998	15.61%	584,151
Bonds	348,850	18,016	1.96%	337,318
Total				921,469
2007	552,881	27,537	5.48%	554,132
Bonds	368,587	18,376	10.21%	385,967
				940,099
2008	564,059	28,087	-36.8%	338,734
Bonds	376,039	18,743	20.1%	429,112
Total				767,846
2009	460,707	28,648	26.3%	545,690
Bonds	307,138	19,117	-11.12%	255,993
Total				801,683
2010	481,009	29,221	15.1%	520,007
Bonds	320,673	19,499	8.46%	326,653
Total				846,660
2011	507,996	29,805	1.9%	487,276
Bonds	338,664	19,888	16.04%	369,907
Total				857,183
2012	514,309	30,401	16%	561,334
Bonds	342,873	20,286	2.97%	332,167
Total				893,501
2013	536,101	31,009	32.2%	667,731
Bonds	357,400	20,691	-9.1%	306,068
Total				973,799

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In both market corrections it got knocked down by about 25%, but was able to get off the mat and fight back. The 2013 portfolio is not at full strength as we are now spending over $51,000 compared to $40,000 in the year 2000. But the portfolio has held up very well due to the inverse relationship between stocks and bonds and the rebalancing that feeds the money back into the best performing asset class - equities.

If I was the retiree in the above scenario, (and given the recent market run) I would immediately pull 2 to 3 years of spending requirements from the portfolio, equally from the stocks and the bonds.

Another option would be to combine the two years of spending (bucketing) with a 60/40 portfolio. After the first two years (end of 2001) the equity value would have been $442,264 and the bond allotment would have totaled $452,594 for a portfolio value of $894,858. That strategy would have seen the portfolio return to an area above $1,000,000 by the end of 2013.

Bucketing plus a nice traditional mix of stocks and bonds appears to be a very prudent approach to the retirement kickoff party. It would appear to offer wonderful peace of mind as well. Certainly a retiree would be able to sleep well in those first two years knowing that the spending is covered by guaranteed cash. Hopefully something is then working on the stock or bond side of the equation. At the very least, the retiree could collect income over the initial two years that would cover the next two years of spending. All told, that's a very low risk way to approach the very crucial initial stages of retirement.

Conclusions

Warren Buffett's suggestion of an equity-heavy portfolio would work in most conditions. But it's not worth the risk of happening into a very unfortunate start date.

It's very important to protect against stock market declines; the tools available are cash, bonds and portfolio income. But make no mistake, a very healthy allocation to the best performing asset class (stocks) is still very, very important.

Happy investing (retiring) and be careful out there.

Disclosure: The author is long SPY, DIA, VYM, EWC, EFA. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. Dale Roberts is an investment funds associate at Tangerine Bank (formerly ING Direct). The Tangerine Investment Portfolios offer complete, low-fee index-based portfolios to Canadians. Dale's commentary does not constitute investment advice. The opinions and information should only be factored into an investor's overall opinion forming process.