Don’t take Warren Buffett’s investing advice literally, but do take it seriously

Warren Buffett is widely regarded as one of the best stock pickers in history. Among the Oracle of Omaha’s most famous pieces of investment advice is: “Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1.”

It goes without saying that when it comes to investing, it is impossible to never lose money. Even the longtime Berkshire Hathaway Inc. chief executive has occasionally taken his lumps. This begs the question of what Buffett meant by his statement. To best interpret his words, I took an “actions speak louder than words” approach and analyzed his historical returns over the 30 years ending December 2022.

In stark contrast, in years when the S&P 500 fell, Buffett gained 4.2 per cent on average. This does not mean he never loses money. In 2008, Berkshire declined 31.78 per cent versus 36 per cent for the S&P 500. However, in down markets, he has either tended to lose far less than the index or not suffer any losses. The latter occurred during 2000-2002, when he gained 29.7 per cent versus a decline of 37.6 per cent for the index.

Fortune’s formula

Very few business school graduates or investment professionals have heard of the Kelly Criterion, which was developed in 1956 by American scientist John Kelly. Despite its relative obscurity and lack of mainstream academic support, the Kelly Criterion has attracted some of the best-known investors on the planet, including Bond King Bill Gross, Renaissance Technologies LLC’s James Simons, Warren Buffett and Charlie Munger (may the great man rest in peace).

The first well-known user of the Kelly Criterion is legendary investor and grandfather of quantitative finance Edward Thorp, who referred to it as “fortune’s formula.” He used Kelly’s theory to develop a system for calculating the odds and altering one’s bets accordingly in blackjack, which forever changed the game.

Thorpe then launched investment firm Princeton Newport Partners (PNP), which produced an annualized return of 15.8 per cent, compared to 10.1 per cent for the S&P 500. PNP achieved this with 75 per cent less volatility than the market and lost money in only three of its 230 months in operation.

When the facts change, I change my mind. What do you do, sir?

John Maynard Keynes

The Kelly Criterion seeks to maximize long-term wealth by optimally adjusting the amounts of capital committed to investments as their expected returns and risks fluctuate. Importantly, the formula dictates you should increase your allocation when the odds are more favourable, and curtail your commitment as the odds deteriorate.

The imperative of adjusting one’s stance in response to changing circumstances was also espoused by John Maynard Keynes, the father of modern macroeconomic theory. When criticized for being inconsistent during a high-profile government hearing, Keynes responded: “When the facts change, I change my mind. What do you do, sir?”

Interestingly, this premise stands in stark contrast to the traditional approach to money management, whereby client portfolios maintain a fixed allocation to stocks, bonds, etc., regardless of changes in the market environment or economic backdrop.

Cash and courage

Having stated that “our favourite holding period is forever,” Buffett is well-known for buying quality companies and holding them for the long term. However, there is another, lesser-known side to his approach that harbours a more-than-subtle resemblance to Kelly’s.

Cash and courage in a time of crisis is priceless

Warren Buffett

Conversely, when downside is limited and compelling prospects are abundant (typically during the uncertainty that reigns during or after a market crash), the opportunity cost of holding cash becomes unjustifiably high. At such times, investors should aggressively deploy their cash holdings into assets that offer higher returns. This sentiment is well-summarized by Buffett’s assertion that “cash and courage in a time of crisis is priceless.”

Many investors lack the courage and/or cash during such times, but Buffett has historically possessed both. During the dot-com bust of 2002, he went on a shopping spree, scooping up companies in several sectors. Similarly, he made several significant investments in beaten-down stocks when global markets were in free fall in late 2008.

The Oracle speaks

As of the end of the third quarter, Berkshire’s combined cash and U.S. Treasury holdings rose to a record US$157.2 billion versus US$93 billion at the end of last year. For the first nine months of 2023, Berkshire was a net seller of US$23.6-billion worth of equities versus US$48.9 billion of net purchases for the first nine months of 2022.

One need look no further than the current ratio of total U.S. stock market value to U.S. gross domestic product to understand why Buffett is proceeding with caution. He has referred to this metric, which is known as the Buffett indicator, as “the best single measure of where valuations stand at any given moment.”

As of the end of October, the Buffett Indicator stood at 160 per cent, which is 1.1 standard deviations above its historical trend line and in the top 14 per cent of observations dating back to 1950.

These manoeuvres do not necessarily imply that Buffett believes a bear market is imminent. However, one could deduce he is skeptical that stocks are poised to deliver meaningful returns over the near/medium term. Relatedly, he is likely of the view that holding larger-than-normal amounts of cash will not entail any opportunity costs, given that rates have risen with a vengeance from their near-zero slumber.

The Oracle may be telling you that there won’t be much to miss and that better opportunities lie ahead. Given his track record, investors would be well-served to keep their FOMO (fear of missing out) instincts in check and their powder dry.

Noah Solomon is chief investment officer at Outcome Metric Asset Management LP.