MONEY

Keeping Calm When the Market Goes South

150305_INV_KEEPCALM
iStock

A financial adviser shares tips for easing anxiety in a rollercoaster market.

“It’s been too good for too long,” my client said.

She had every right to feel suspicious. With the markets appearing to be at an all-time high, she was justified in having that waiting-for-the-other-shoe-to-drop instinct. I understood her desire to tread cautiously.

The majority of baby boomers are at a crossroad in their lives: They want to retire, they should retire, and it’s time to retire. But they are extremely nervous nowadays about the markets’ record-breaking levels.

Over my many years of experience working with clients in this situation — they’re ready to retire, but they can’t quite pull the trigger — I’ve seen how scary it can be to make that potentially irrevocable decision. What if markets go down? Should they have waited? What if this, what if that?

It is human nature to question ourselves at times like these, but then again, times are always a bit uncertain.

I have found that the most important step in keeping clients calm in a volatile market is to have an investment education meeting regarding their risk level and market volatility at the start of our working relationship and routinely thereafter. Our clients are actively involved in assessing their own risk tolerance and choosing a portfolio objective that suits their long-term goals.

We also want to set the right expectation of our management so our clients know that we never sell out of the market just because things are starting to go bad. Market timing has not proven to be a successful growth strategy, which is why we work with our clients upfront to establish a portfolio and game plan they can live with.

Unfortunately, the inevitable will happen: The markets will go south, and clients will panic. How can financial planners ease clients’ anxiety? Here are a few suggestions:

  • Discuss defensive tactics. Show clients the dollar amounts they have in bonds and other fixed income. Translate that into the number of years’ worth of personal spending that is not in the stock market. Have an honest conversation about if that number will be enough over the long-term.
  • Leave emotion out of it. Talk to them about the danger of selling at the wrong time and illustrate how emotional decisions tend to do more harm than good. Remind them of how quickly markets can turn around after a big drop. It’s been known to happen on more than one occasion, so share your knowledge of these experiences. Let them know that you don’t want them to miss the upside.
  • Look at the positives. Reinvesting dividends and capital gains? Are clients making monthly contributions to a 401(k) or other investment accounts? Remind your clients that when markets are down they are buying at lower prices, which can work well for their strategy over the longer term. A down market also often makes investing easier and less frightening to buy, so that might be the time to purchase any equities they once worried were too expensive.

The markets will always have some level of volatility. As an adviser providing regular guidance and support, you want to do everything you can to help clients not overreact to the daily news, hard as it might be. Urge them to continue to think long-term. It may not always be easy to see, but today’s bad news may just be a client’s big buy opportunity, and they won’t want to miss that!

———-

Marilyn Plum, CFP, is director of portfolio management and co-owner of Ballou Plum Wealth Advisors, a registered investment adviser in Lafayette, Calif. She is also a registered representative with LPL Financial. With over 30 years of experience in the financial advisory business, Plum is well-known for financial planning expertise and client education on wealth preservation, retirement, and portfolio management.

MONEY stocks

10 Smart Ways to Boost Your Investing Results

stacks of coins - each a different color
Alamy

You don't have to be an investing genius to improve your returns. Just follow a few simple steps.

Recent research shows that people who know their way around investing and finance racked up higher annual returns (9.5% vs. 8.2%) than those who don’t. Here are 10 tips that will help make you a savvier investor and better able to achieve your financial goals.

1. Slash investing fees. You can’t control the gains the financial markets deliver. But by sticking to investments like low-cost index funds and ETFs that charge as little as 0.05% a year, you can keep a bigger portion of the returns you earn. And the advantage to doing so can be substantial. Over the course of a career, reducing annual fees by just one percentage point can boost the size of your nest egg more than 25%. Another less commonly cited benefit of lowering investment costs: downsizing fees effectively allows you to save more for retirement without actually putting aside another cent.

2. Beware conflicted advice. Many investors end up in poor-performing investments not because of outright cons and scams but because they fall for a pitch from an adviser who’s really a glorified salesman. The current push by the White House, Department of Labor and Securities and Exchange Commission to hold advisers to a more rigorous standard may do away with some abuses. But the onus is still on you to gauge the competence and trustworthiness of any adviser you deal with. Asking these five questions can help you do that.

3. Gauge your risk tolerance. Before you can invest properly, you’ve got to know your true appetite for risk. Otherwise, you could end up bailing out of investments during market downturns, turning paper losses into real ones. Completing a risk tolerance questionnaire like this one from RealDealRetirement’s Retirement Toolbox can help you assess how much risk you can reasonably handle.

4. Don’t be a “bull market genius.” When the market is doing well and stock prices are surging, it’s understandable if you assume your incredible investing acumen is responsible for those outsize returns. Guess what? It’s not. You’re really just along for the ride. Unfortunately, many investors lose sight of this basic fact, become overconfident, take on too much risk—and then pay dearly when the market inevitably takes a dive. You can avoid such a come-down, and the losses that accompany it, by leavening your investing strategy with a little humility.

5. Focus on asset allocation, not fund picking. Many people think savvy investing consists of trying to identify in advance the investments that will top the performance charts in the coming year. But that’s a fool’s errand. It’s virtually impossible to predict which stocks or funds will outperform year to year, and trying to do so often means you’ll end up chasing hot investments that may be more prone to fizzle than sizzle in the year ahead. The better strategy: create a diversified mix of stock and bond funds that jibes with your risk tolerance and makes sense given the length of time you plan to keep your money invested. That will give you a better shot at getting the long-term returns you need to achieve a secure retirement and reach other goals while maintaining reasonable protection against market downturns.

6. Limit the IRS’s take. You should never let the desire to avoid taxes drive your investing strategy. That policy has led many investors to plow their savings into all sorts of dubious investments ranging from cattle-breeding operations to jojoba-bean plantations. That said, there are reasonable steps you can take to prevent Uncle Sam from claiming too big a share of your investment gains. One is doing as much of your saving as possible in tax-advantaged accounts like traditional and Roth 401(k)s and IRAs. You may also be able to lower the tab on gains from investments held in taxable accounts by investing in stock index funds and tax-managed funds that that generate much of their return in the form of unrealized long-term capital gains, which go untaxed until you sell and then are taxed at generally lower long-term capital gains rates.

7. Go broad, not narrow. In search of bigger gains, many investors tend to look for niches to exploit. Instead of investing in a broad selection of energy or technology firms, they’ll drill down into solar producers, wind power, robotics, or cloud-computing firms. That approach might work, but it can also leave you vulnerable to being in the wrong place at the wrong time—or the right place but the wrong company. Going broader is better for two reasons: it’s less of a guessing game, and the broader you go the lower your investing costs are likely to be. So if you’re buying energy, tech or whatever, buy the entire sector. Better get, go even broader still. By investing in a total U.S. stock market and total U.S. bond market index fund, you’ll own a piece of virtually all publicly traded U.S. companies and a share of the entire investment-grade bond market. Throw in a total international stock index fund and you’ll have foreign exposure as well. In short, you’ll tie your portfolio’s success to that of the broad market, not just a slice of it.

8. Consider the downside. Investors are by and large an optimistic lot, otherwise they wouldn’t put their money where their convictions are. But a little skepticism is good too. So before putting your money into an investment or embarking on a strategy, challenge yourself. Come up with reasons your view might be all wrong. Think about what might happen if you are. Crash-test your investing strategy to see how you’ll do if your investments don’t perform as well as you hope. Better to know the potential downside before it occurs than after.

9. Keep it simple. You can easily get the impression that you’re some kind of slacker if you’re not filling your portfolio with every new fund or ETF that comes out. In fact, you’re better off exercising restraint. By loading up on every Next Big Thing investment the Wall Street marketing machine churns out you run the risk of di-worse-ifying rather than diversifying. All you really need is a portfolio that mirrors the broad U.S. stock and bond markets, and maybe some international exposure. If you want to go for more investing gusto, you can consider some inflation protection, say, a real estate, natural resources, or TIPS fund. But I’d be wary about adding much more than that.

10. Tune out the noise. With so many investing pundits weighing in on virtually every aspect of the financial markets nearly 24/7, it’s easy to get overwhelmed with advice. It might make sense to sift through this cacophony if it were full of investing gems, but much of the advice, predictions, and observations are trite, if not downright harmful. If you want to watch or listen to the parade of pundits just to keep abreast of the investing scuttlebutt, fine. Just don’t let the hype, the hoopla, and the hyperbole distract you from your investing strategy.

Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at walter@realdealretirement.com.

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MONEY Oil

3 Reasons Gas Prices Could Rocket Higher

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Scott Olson—Getty Images Members of the United Steelworkers Union and other supporting unions picket outside the BP refinery.

Unfortunately, the days of $2 gas appear to be in the rearview mirror.

Well, we had a nice run. After 123 straight days of falling gasoline prices, sending it below $2 a gallon in many states, we’ve come back to reality a little bit. In fact, gas prices have now risen each and every day for about a month. Unfortunately, gas prices could go a lot higher because of three storm clouds that appear to be on the horizon, which could combine to send gas prices rocketing higher.

Storm cloud No. 1: Rising oil prices

The dramatic drop in the price of oil in late 2014 caused gas prices to come down as well. We see this correlation in the following chart:

Brent Crude Oil Spot Price Chart

 

As we see there, the price of oil is down 45% over the past year, while the price of gasoline is down 32%. However, we can also see that both have bounced off of their bottoms from earlier this year. That’s because the price of oil has stabilized and is now starting to head higher as the oil market starts to see signs that it is working out some of its supply/demand imbalance issues.

Because those issues are being addressed, the oil market is now starting to point to a higher oil price later this year. That’s a recipe for higher gas prices, which is just what the U.S. Energy Information Administration is predicting, as we can see on the chart below.

Storm cloud No. 2: The big switch

One other thing you might have noticed from that above chart is that the price of gasoline is notably more lumpy than the price of oil. It’s something most of us notice at the pump each year as gas prices almost always rise in the spring. That’s because summer driving season is upon us, which leads to more demand for gasoline.

However, what really drives the price of gas up isn’t so much increased demand for gasoline in the summer, but the fact that oil refineries need to shift gears in the spring to focus on refining summer-blend fuels as opposed to winter-blend gasoline and home heating oil. Along with this switch, refiners also tend to undergo routine maintenance in the spring, which reduces their refining capacity. This adds up, and over the past few years on average, this has added $0.54 per gallon to the cost of gasoline each spring.

Storm cloud No.3: The picket line

This year, there’s a new wrinkle that could throw a wrench in the spring refinery maintenance season. The refining industry is currently at odds with the United Steelworkers union as the two have failed to reach an agreement on a new contract. As the dispute grows, workers at a dozen U.S. refineries have walked off the job, putting 19% of U.S. refining capacity at risk. The strike could continue to expand, as neither party is giving much ground on the disputed issues. This could lead to up to 63 refineries, which represent two-thirds of refining capacity, being affected by the strike.

So far, the strike has only resulted in one refinery in California being shut down, and that’s just because it was already undergoing maintenance, and its owner decided not to run the plant. However, shortly thereafter, an explosion at another California refinery took that facility offline, too, and cut the state’s refining capacity by 25%. This resulted in gas prices spiking in Los Angeles by $0.50 per gallon. This suggests that should the growing labor dispute lead to refineries across the nation shutting down, it could cause a big spike in what we pay at the pump.

Bottom line

Unfortunately, the days of $2 gas appear to be in the rearview mirror. Even without the rally in the oil price over the past few weeks, gas prices would have headed higher because of the normal spring switchover at refineries. However, this year, the price of gas could be under even more pressure to rise because of the possibility of a continued increase in the price of oil, and the possibility that the refinery strike causes a big portion of refining capacity to be taken offline.

I know that’s not the greatest of news, but if gas prices do spike, at least you’ll know why. And it’s a good reminder that instead of complaining about gas prices, an investment in the oil industry could offset some of the extra costs we’ll be paying at the pump and take away a bit of the sting of spiking prices.

MONEY Food & Drink

5 Reasons Why McDonald’s Will Win in 2015

McDonald's golden arches signs
Kristoffer Tripplaar—Alamy

McDonald's may not look so hot now, but it's in great shape to beat the market in 2015.

It’s so easy to kick a mustard- and ketchup-colored clown when it’s down, and McDonald’s MCDONALD'S CORP. MCD -0.7% has certainly earned the dissing.

It’s coming off of five consecutive quarters of negative comps, and lately it’s been blasted for everything from the quality of its grub to operational snags.

Instead of piling on, let’s take a look at a few of the things that either have been going right or should start to go right for McDonald’s this year.

1. Domestic comps are growing again

The market wasn’t impressed when McDonald’s announced that global comparable sales decreased 1.8% in January. It’s just something that the market has grown used to since the chain’s fundamentals began to slip in late 2013. However, the entirety of that decline was the result of fallout in Asia as a supplier scare in China and brand perception issues in Japan weighed on the overall performance.

The world’s largest burger chain held up better closer to home. Sales in the U.S. rose 0.4%, with an even better 0.5% year-over-year uptick at the register in Europe. Boo birds will argue this still means sales aren’t keeping up with inflation, but let’s frame this correctly. This is the first month in more than a year that McDonald’s has posted comps that are north of breakeven.

2. The new CEO could be a game changer

The Don Thompson era is coming to a close, and now the board is tasking Steve Easterbrook with turning the chain around as its new CEO. Yes, he’s an internal hire. That may not seem very exciting at a time when McDonald’s needs to think outside of the Happy Meal box, but he seems like the perfect candidate.

Easterbrook helped turn around the chain’s operations in Europe before moving back to head up the restaurant’s marketing department. He seems to have a firm grasp on the right message to woo back customers, and January’s bounce could be the first sign.

3. Higher wages could benefit McDonald’s

Consumer-facing chains are under fire for their low wages, and it wouldn’t be a surprise if we see restaurant operators start to pay more this year. This will naturally inflate prices, but McDonald’s may have a technological advantage in the form of automation.

McDonald’s and its franchisees have been investing in machines that perform many mundane tasks. Smoothie machines get going at the press of a button. Updated drive-thru windows have soda fountain carousels that sort out cups and fill them with beverages as they are ordered. Smaller chains can’t afford these high-tech automations, but it also means that McDonald’s will be able to get by with fewer employees in the future.

4. The improving economy will raise all chains

Have you noticed the drive-thru lane at your local McDonald’s getting longer in the morning? I have. With job creation on the rise again we’re seeing more rushed commuters hitting the road, taking lunch breaks, and having more money at the end of the day to take their families out to dinner.

This is a trend that should be beneficial to all chains. McDonald’s will be there.

5. The fundamentals are strong

McDonald’s may not seem cheap for a mature and slow-growing company. The stock is trading at 19 times this year’s expected earnings and a still steep 18 times next year’s target. However, there’s something to be said about a company with a predictable stream of fat royalty payments from franchisees. Net profit margins at McDonald’s hovered around a juicy 20% for several years before last year’s stumble, according to S&P Capital IQ data.

Along the way we have a company donning a chunky yield of 3.5% with a history of annual hikes dating back to when it started paying out dividends 39 years ago. McDonald’s may not look so hot now, but it’s in great shape to beat the market in 2015.

MONEY Inequality

Why the Nasdaq Is Back but the Middle Class Isn’t

The Times Square news-ticker announces the NASDAQ composite index topping 5,000 points on March 2, 2015 in New York City. The NASDAQ composite climbed over 5,000 points for the first time in 15 years.
Bryan Thomas—Getty Images The Times Square news-ticker announces the NASDAQ composite index topping 5,000 points on March 2, 2015 in New York City. The NASDAQ composite climbed over 5,000 points for the first time in 15 years.

Why the average American has missed out on the stock market's gains.

The Nasdaq touched 5,000 on Monday and investors are having some heady Y2K flashbacks. The tech-heavy index last approached such lofty heights in 2000, when the stock market bubble had yet to pop. It was time when electronic trading, tech funds and hot IPOs were middle class obsessions. It felt like everyone could get a piece of the action.

There’s some of that boom-boom feeling in air again. (See: Uber, Shake Shack and the growing herd of “unicorns,” Silicon-Valley-speak for start-ups valued at $1 billion.) But while the Nasdaq index has returned to prosperity, this stock rally in general has felt like, in investment blogger Josh Brown’s words, a rich man’s bubble. For one thing, for better or for worse, the percentage of adults invested in the stock market is at its lowest point in decades. The financial crisis forced many middle-income investors to liquidate their stock holdings in order to weather the following years of financial hardship.

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And nobody is under the illusion that everyone’s getting rich.

A study financed by the Russell Sage foundation found that the median household’s net worth declined by $32,000 between 2003 and 2013, from almost $87,992 to $56,335. That means a typical household lost 36% of its wealth in 10 years. Yet in that same 10 year time-span, not only the Nasdaq has boomed back. The S&P 500, the most commonly used indicator of stock market health, is up 60%.

The fact that fewer Americans are invested in the market is only part of the issue. Study co-author Fabian Pfeffer says home equity made up more than half of the median household’s wealth in 2007, just before the housing crash. Worse, the housing market has improved far more slowly than the stock market, resulting in a much slower recovery for middle-income households.

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And so volatility has tended to amplify inequality, even when markets eventually bounce back. While the average American was forced to divest from the stock market when shares were (in hindsight now) cheap, wealthier people were not, meaning the latter group has benefited more when the economy improved. Wealthier Americans also had a higher percentage of their wealth outside the real estate market. Pfeffer says the median household in the richest 5th percentile held just 16% of their wealth in home equity, with the rest primarily held in either business assets (49%) or financial instruments like stocks and bonds (25%).

The end result? America’s wealthiest households prospered in the aftermath of the financial crisis as the stock market improved, while the middle class was largely passed over. Pfeffer’s research found the richest 5% of Americans held 24 times the wealth of the median household in 2013, up from 13 times the wealth of a typical household in 2003. In other words, wealth inequality essentially doubled over the last decade.

MONEY Warren Buffett

The 6 Most Important Quotes From Warren Buffett’s Greatest Shareholder Letter Ever

Warren Buffett
Nati Harnik—AP

Why did Berkshire under Buffett do so well?

Last week, Berkshire Hathaway released its 2014 shareholder letter. Warren Buffett’s letter, always closely followed, was particularly anticipated this year. Indeed, as this year will mark a half-century of Berkshire Hathaway under “current management,” Buffett had promised two “looking back/looking forward” analyses, one from his pen and one from that of his partner, Berkshire Vice Chairman Charlie Munger.

Here are some of the key quotes from this year’s letter. (I’ve identified those that come from Munger.)

Buffett’s successor: one of two men?

With Buffett now 84, Berkshire’s succession plan is a matter of intense speculation. His latest comments on the matter (my emphasis):

Our directors believe that our future CEOs should come from internal candidates whom the Berkshire board has grown to know well. Our directors also believe that an incoming CEO should be relatively young, so that he or she can have a long run in the job. Berkshire will operate best if its CEOs average well over 10 years at the helm. (It’s hard to teach a new dog old tricks.) And they are not likely to retire at 65 either (or have you noticed?). … Both the board and I believe we now have the right person to succeed me as CEO — a successor ready to assume the job the day after I die or step down. In certain important respects, this person will do a better job than I am doing.

Who might the successor be? Munger offers a clue that appears to narrow it down to two individuals (my emphasis):

But under this Buffett-soon-leaves assumption, his successors would not be “of only moderate ability.” For instance, Ajit Jain and Greg Abel are proven performers who would probably be under-described as “world-class.” “World-leading” would be the description I would choose. In some important ways, each is a better business executive than Buffett.

Berkshire Hathaway Reinsurance head Ajit Jain is 63, and Berkshire Hathaway Energy CEOGreg Abel is 52. In terms of age and expected tenure, Abel has the advantage.

The timing of the elusive Berkshire dividend

Another recurring debate in the financial media is the value and timing of a potential Berkshire dividend — although, as we shall see, it’s not much of a debate among shareholders. Buffett provides his first time-bound guidelines:

Eventually — probably between 10 and 20 years from now — Berkshire’s earnings and capital resources will reach a level that will not allow management to intelligently reinvest all of the company’s earnings. At that time our directors will need to determine whether the best method to distribute the excess earnings is through dividends, share repurchases, or both. If Berkshire shares are selling below intrinsic business value, massive repurchases will almost certainly be the best choice. You can be comfortable that your directors will make the right decision.

That doesn’t appear to be a problem for current shareholders:

Nevertheless [in response to last year’s proxy motion requesting a dividend], 98% of the shares voting said, in effect, “Don’t send us a dividend but instead reinvest all of the earnings.” To have our fellow owners — large and small — be so in sync with our managerial philosophy is both remarkable and rewarding. I am a lucky fellow to have you as partners.

Munger’s contribution to Berkshire

Although he has remained in Buffett’s shadow over the past 50 years, it’s almost impossible to overstate Munger’s contribution to Berkshire Hathaway. Buffett pays tribute to it:

From my perspective, though, Charlie’s most important architectural feat was the design of today’s Berkshire. The blueprint he gave me was simple: Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices. … Charlie never tired of repeating his maxims about business and investing to me, and his logic was irrefutable. Consequently, Berkshire has been built to Charlie’s blueprint. My role has been that of general contractor, with the CEOs of Berkshire’s subsidiaries doing the real work as sub-contractors.

The 4 keys to Berkshire’s success

Munger returns Buffett’s compliment:

Why did Berkshire under Buffett do so well?

Only four large factors occur to me: (1) the constructive peculiarities of Buffett, (2) the constructive peculiarities of the Berkshire system, (3) good luck, and (4) the weirdly intense, contagious devotion of some shareholders and other admirers, including some in the press.

I believe all four factors were present and helpful. But the heavy freight was carried by the constructive peculiarities, the weird devotion, and their interactions. In particular, Buffett’s decision to limit his activities to a few kinds and to maximize his attention to them, and to keep doing so for 50 years, was a lollapalooza. Buffett succeeded for the same reason Roger Federer became good at tennis.

Buffett was, in effect, using the winning method of the famous basketball coach John Wooden, who won most regularly after he had learned to assign virtually all playing time to his seven best players. That way, opponents always faced his best players, instead of his second best. And, with the extra playing time, the best players improved more than was normal.

And Buffett much out-Woodened Wooden, because in his case the exercise of skill was concentrated in one person, not seven, and his skill improved and improved as he got older and older during 50 years, instead of deteriorating like the skill of a basketball player does.

The Berkshire system: 15 rules for building a world-leading conglomerate

What is this “Berkshire system” Munger refers to, which has been at the core of Berkshire’s unparalleled success? He codifies it in 15 points:

The management system and policies of Berkshire under Buffett (herein together called “the Berkshire system”) were fixed early and are described below:

(1) Berkshire would be a diffuse conglomerate, averse only to activities about which it could not make useful predictions.

(2) Its top company would do almost all business through separately incorporated subsidiaries whose CEOs would operate with very extreme autonomy.

(3) There would be almost nothing at conglomerate headquarters except a tiny office suite containing a chairman, a CFO, and a few assistants who mostly helped the CFO with auditing, internal control, etc.

(4) Berkshire subsidiaries would always prominently include casualty insurers. Those insurers as a group would be expected to produce, in due course, dependable underwriting gains while also producing substantial “float” (from unpaid insurance liabilities) for investment.

(5) There would be no significant systemwide personnel system, stock option system, other incentive system, retirement system, or the like, because the subsidiaries would have their own systems, often different.

(6) Berkshire’s chairman would reserve only a few activities for himself. […]

(7) New subsidiaries would usually be bought with cash, not newly issued stock.

(8) Berkshire would not pay dividends so long as more than one dollar of market value for shareholders was being created by each dollar of retained earnings.

(9) In buying a new subsidiary, Berkshire would seek to pay a fair price for a good business that the chairman could pretty well understand. Berkshire would also want a good CEO in place, one expected to remain for a long time and to manage well without need for help from headquarters.

(10) In choosing CEOs of subsidiaries, Berkshire would try to secure trustworthiness, skill, energy, and love for the business and circumstances the CEO was in.

(11) As an important matter of preferred conduct, Berkshire would almost never sell a subsidiary.

(12) Berkshire would almost never transfer a subsidiary’s CEO to another unrelated subsidiary.

(13) Berkshire would never force the CEO of a subsidiary to retire on account of mere age.

(14) Berkshire would have little debt outstanding as it tried to maintain (i) virtually perfect creditworthiness under all conditions and (ii) easy availability of cash and credit for deployment in times presenting unusual opportunities.

(15) Berkshire would always be user-friendly to a prospective seller of a large business. An offer of such a business would get prompt attention. No one but the chairman and one or two others at Berkshire would ever know about the offer if it did not lead to a transaction. And they would never tell outsiders about it.

Both the elements of the Berkshire system and their collected size are quite unusual. No other large corporation I know of has half of such elements in place.

The continued success of Berkshire after Buffett

Will the “Berkshire system” ensure continued success, despite its size, and after Buffett? Buffett says yes:

Despite our conservatism, I think we will be able every year to build the underlying per-share earning power of Berkshire. That does not mean operating earnings will increase each year — far from it. The U.S. economy will ebb and flow — though mostly flow — and when it weakens, so will our current earnings. But we will continue to achieve organic gains, make bolt-on acquisitions, and enter new fields. I believe, therefore, that Berkshire will annually add to its underlying earning power.

Munger concurs:

The next to last task on my list was: Predict whether abnormally good results would continue at Berkshire if Buffett were soon to depart. The answer is yes. Berkshire has in place in its subsidiaries much business momentum grounded in much durable competitive advantage. Moreover, its railroad and utility subsidiaries now provide much desirable opportunity to invest large sums in new fixed assets. And many subsidiaries are now engaged in making wise “bolt-on” acquisitions.

Provided that most of the Berkshire system remains in place, the combined momentum and opportunity now present is so great that Berkshire would almost surely remain a better-than-normal company for a very long time even if (1) Buffett left tomorrow, (2) his successors were persons of only moderate ability, and (3) Berkshire never again purchased a large business.

These quotes provide some of the important lessons from this year’s letter, but the document is extraordinarily rich in business and investing lessons and will be analyzed and debated for years to come — including here on Fool.com. Be sure to check back in the next few days for more coverage of the 2014 Berkshire Hathaway shareholder letter.

MONEY Warren Buffett

The Guy Who Made a $1 Million Bet Against Warren Buffett

Warren Buffett
Nati Harnik—AP

Even if hedge funds were winning—which they aren't—you still should be in indexes.

Warren Buffett bet a prominent U.S. hedge fund manager in 2008 that an S&P 500 index fund would beat a portfolio of hedge funds over the next ten years. How’s it going?

“We’re doing quite poorly, as it turns out,” president of Protege Partners Ted Seides, who made the bet with Buffett, told Marketplace Morning Report today. In fact, an S&P 500 fund run by Vanguard rose more than 63%, while the other side of the wager, a portfolio of funds that only invest in hedge funds, has only returned 20% after fees.

The fees are the important component. When the two sides made their respective cases for why they would win, Buffett noted that active investors incur much higher expenses than index funds in their quest to outperform the market. These costs only increase with hedge funds, or a fund of hedge funds, thus stacking the deck even more in his favor.

“Funds of hedge funds accentuate this cost problem because their fees are superimposed on the large fees charged by the hedge funds in which the funds of funds are invested,” Buffett argued at the time. “A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors.”

Before fees, Seides’s picks would be up 44%—still almost twenty percentage points behind Buffett, but way ahead of where they are.

Seides, to his credit, has been transparent. “Standing seven years into a 10-year wager with Warren Buffett, we sure look wrong,” he wrote in a recent blog post for CFA Institute. He went on to cite the Federal Reserve, both for its decision to keep interest rates at basically zero and undertake an unconventional bond-buying program to jumpstart the economy in the wake of the Great Recession, as one reason why his portfolio has been so roundly beaten by the S&P 500. Of course, investors inability to consistently foresee and time major market events is one reason why index funds are so powerful. (He also points out that a broad stock market index fund is a poor measuring stick for hedge fund performance.)

There’s still three years left in the bet, but barring a prolonged stock market crash, Girls Incorporated of Omaha—Buffett’s charity of choice—seems well placed to win. (The size of that donation stands right now at more than $1.5 million, for reasons having to do with zero-coupon bonds.) Those who are inclined to support passive investing, like MONEY, can be satisfied that once again indexes trumped active traders.

Now here’s the thing: Seven years ago, Seides’ chances of winning this bet actually weren’t so terrible. Cheap index funds have a strong statistical edge over active managers, but that doesn’t mean every stock picker loses. Last December, S&P Dow Jones Indices published “The Persistence Scorecard,” which measures whether outperforming fund managers in one year can continue to outperform the market going forward. “Out of 681 funds that were in the top quartile as of September 2012, only 9.8% managed to stay in the top quartile at the end of September 2014,” according to the report. While that’s not a terribly good record, about 10% of portfolio managers (and their shareholders) think that they are clever investors.

The trouble is, they probably won’t be in the top 10% of investors over the next ten years. There will always be market beaters, even if just by random (and unfortunately unpredictable) chance. That fact goes a long way towards keeping money managers in business.

So when you hear a hot-shot alpha investor type say that he’s beaten the market over the last couple of years, just remember: Stuff happens.

MONEY Warren Buffett

Warren Buffett’s Secret to Staying Young: 5 Cokes a Day

150226_INV_WarrenBuffettCoke
Daniel Acker—Bloomberg via Getty Images Warren Buffett, chief executive officer of Berkshire Hathaway, drinks a Cherry Coca-Cola.

The world’s most successful investor stays youthful by eating "like a 6-year-old." Turns out, the Berkshire Hathaway CEO’s bizarre diet is highly strategic.

How does the world’s top investor, at 84 years old, wake up every day and face the world with boundless energy?

“I’m one quarter Coca-Cola,” Warren Buffett says.

When he told me this in a phone call yesterday (we were talking about the death of his friend, former Coca-Cola president Don Keough), I assumed he was talking about his stock portfolio.

No, Buffett explained, “If I eat 2700 calories a day, a quarter of that is Coca-Cola. I drink at least five 12-ounce servings. I do it everyday.”

Perhaps only a man who owns $16 billion in Coca-Cola KO 0.71% stock—9% of Coke, through his company, Berkshire Hathaway BRK.A -0.23% —would maintain such an odd daily diet. One 12-ounce can of Coke contains 140 calories. Typically, Buffett says, “I have three Cokes during the day and two at night.”

When he’s at his desk at Berkshire Hathaway headquarters in Omaha, he drinks regular Coke; at home, he treats himself to Cherry Coke.

“I’ll have one at breakfast,” he explains, noting that he loves to drink Coke with potato sticks. What brand of potato sticks? “I have a can right here,” he says. “U-T-Z” Utz is a Hanover, Pennsylvania-based snack maker. Buffett says that he’s talked to Utz management about potentially buying the company.

Investors in Berkshire Hathaway may feel relieved that the CEO isn’t addicted to Utz Potato Stix at every breakfast. “This morning, I had a bowl of chocolate chip ice cream,” Buffett says.

Asked to explain the high-sugar, high-salt diet that has somehow enabled him to remain seemingly healthy, Buffett replies: “I checked the actuarial tables, and the lowest death rate is among six-year-olds. So I decided to eat like a six-year-old.” The octogenarian adds, “It’s the safest course I can take.”

This article originally appeared on Fortune.com.

MONEY investing strategy

The Track Records of Wall Street’s Top Strategists Are Worse Than You Think

fever graph on screen
Richard Drew—AP

Listening to Wall Street's top strategists is no better than random guessing.

This is embarrassing.

There are 22 “chief market strategists” at Wall Street’s biggest banks and investment firms. They work at storied firms such as Goldman Sachs and Morgan Stanley. They have access to the best information, the smartest economists, and teams of brilliant analysts. They talk to the largest investors in the world. They work hard. They are paid lots of money.

One of their most important — and certainly highest-profile — jobs is forecasting what the stock market will do over the next year. Strategists do this every January by predicting where the S&P 500 will close on Dec. 31.

You won’t be shocked to learn their track record isn’t perfect. But you might be surprised at how disastrously bad it is. I certainly was.

On average, chief market strategists’ forecasts are worse than those made by a guy I call the Blind Forecaster. He’s a brainless idiot who assumes the market goes up 9% — its long-term historic average — every year, regardless of circumstances.

Here’s the average strategist’s forecast versus actual S&P 500 performance since 2000:

Some quick math shows the strategists’ forecasts were off by an average of 14.7 percentage points per year.

How about the Blind Forecaster? Assuming the market would rise 9% every year since 2000 provided a forecast that was off by an average of 14.1 percentage points per year.

Underperforming the Blind Forecaster isn’t due to 2008, which forecasters like to write off as an unforeseeable “black swan.” Excluding 2008, the strategists’ error rate is 12 percentage points per year, versus 11.6 percentage points per year for the Blind Forecaster. Our idiot still wins.

The Blind Forecaster wasn’t a good forecaster, mind you. He was terrible. He missed bear markets and underestimated bull markets. In only one of the last 14 years was his annual forecast reasonably close to being accurate. But he was still better than the combined effort of 22 of Wall Street’s brightest analysts.

And the Blind Forecaster required no million-dollar salary. He worked no late nights. He attended no conference calls, meetings, or luncheons. He made no PowerPoint presentations, and never appeared on CNBC. He has no beach house, and was granted no bonuses. He works free of charge, offering his services to anyone who will listen.

Amazingly, these stories aren’t rare. In 2007, economists Ron Alquist and Lutz Kilian looked atcrude futures, a market used to predict oil prices. These markets were actually less accurate at predicting oil prices than a naïve “no-change” forecast, which assumes the future price of oil is whatever the current price is now. The no-change forecast was terrible at predicting oil prices, of course. But it was better than the collective effort of the futures market.

This raises two questions: Why do people listen to strategists? And why are they so bad?

The first question is easy. I think there’s a burning desire to think of finance as a science like physics or engineering.

We want to think it can be measured cleanly, with precision, in ways that make sense. If you think finance is like physics, you assume there are smart people out there who can read the data, crunch the numbers, and tell us exactly where the S&P 500 will be on Dec. 31, just as a physicist can tell us exactly how bright the moon will be on the last day of the year.

But finance isn’t like physics. Or, to borrow an analogy from investor Dean Williams, it’s not like classical physics, which analyzes the world in clean, predictable, measurable ways. It’s more like quantum physics, which tells us that — at the particle level — the world works in messy, disorderly ways, and you can’t measure anything precisely because the act of measuring something will affect the thing you’re trying to measure (Heisenberg’s uncertainty principle). The belief that finance is something precise and measurable is why we listen to strategists. And I don’t think that will ever go away.

Finance is much closer to something like sociology. It’s barely a science, and driven by irrational, uninformed, emotional, vengeful, gullible, and hormonal human brains.

If you think of finance as being akin to physics when it’s actually closer to sociology, forecasting becomes a nightmare.The most important thing to know to accurately forecast future stock prices is what mood investors will be in in the future. Will people be optimistic, and willing to pay a high price for stocks? Or will they be bummed out, panicked about some crisis, pissed off at politicians, and not willing to pay much for stocks? You have to know that. It’s the most important variable when predicating future stock returns. And it’s unknowable. There is no way to predict what mood I’ll be in 12 months from now, because no matter what you measure today, I can ignore it a year from now. That’s why strategists have such a bad record.

Worse than a Blind Forecaster.

Check back every Tuesday and Friday for Morgan Housel’s columns.

The more you know about the most common mistakes that investors make, the better your likelihood of building lasting wealth. Click here for more commentary on how I think about investing and money.

Contact Morgan Housel at mhousel@fool.com. The Motley Fool has a disclosure policy.

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MONEY Tech

Why Apple Won’t Buy Tesla

Tesla Model S
Tesla Tesla Model S

It doesn't make any sense.

According to Jason Calacanis, who bills himself as an “angel investor, entrepreneur, conference host, and podcaster,” Apple APPLE INC. AAPL -0.82% will spend $75 billion to acquire Tesla Motors TESLA MOTORS INC. TSLA -2.76% within the next year-and-a-half. While he listed a number of reasons for such a deal, his primary argument is that “once the [Tesla] Model 3 hits the road, Tesla’s market cap would make a deal with Apple a merger — not an acquisition.”

In other words, Calacanis expects such a sharp upturn in Tesla financials once it launches the more affordable Model 3 car that its market capitalization could be well north of what even Apple could afford — assuming, of course, Apple even wants to buy Tesla.

But this seems highly implausible to me.

Tesla is already quite richly valued

The first fundamental flaw with this claim is the idea that Tesla financials and market capitalization will skyrocket once the company is delivering relatively affordable electric vehicles in significant volumes. I would argue the current $25 billion market capitalization already bakes in some pretty high investor expectations.

To put this into perspective, current analyst consensus for Ford 2015 revenue — keep in mind that Ford is already in the high-volume, mainstream automobile game — sits at $143.7 billion, and its market capitalization is just shy of $64 billion as of this writing. Tesla trades at approximately 39% of Ford’s market capitalization even though the upstart carmaker is projected to generate just 4% of its 2015 revenue.

Of course, Tesla is a much higher-growth company, and it is far “sexier” than Ford, so I do not take issue with Tesla getting a richer valuation. The problem, though, is that the stock price today — at least, from what I can tell — already bakes in a lot of future success.

That means when or if Tesla succeeds in driving more volume and growing its revenue significantly, the financials might improve, but I am not convinced this could lead to the huge growth in the stock price that Calacanis predicts.

Apple would be better off buying its own stock

If Apple were to drop $75 billion on Tesla today (a three times premium to the current market capitalization), it is highly questionable as to when the company could see a return on that investment. Tesla has outright stated it does not expect to be profitable on a GAAP basis until 2020.

In this scenario, not only would Apple have to wait five years before a single cent of profit showed up on the income statement, but Tesla operations could actually drag on Apple. If the company owns Tesla, and Tesla is losing money, then that comes straight out of Apple financials.

Additionally, since Apple would need to buy Tesla with U.S.-based cash or with stock, the deal would either force the tech giant to issue shares, undoing the benefits of previous stock repurchases, or to issue a hefty amount of debt, which means paying interest on that debt. Alternatively, Apple could repatriate its foreign-held cash and get hit with a huge tax bill, but that would probably be the least likely option.

If Apple is really itching to spend $75 billion on something, it would be far better for the company to simply buy back stock. At least in this case, Apple would shrink the number of shares outstanding, immediately providing a meaningful boost to earnings per share. In my humble view, that would certainly be a quicker and easier way to juice the bottom line than to spend an exorbitant amount of money on Tesla.

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