Can we learn some lessons from one of the world’s most legendary investors? Warren Buffett has attacked the orthodox definition of investment “safety.”
As usual, Buffett nails the problem quite succinctly: Rather than measuring risk by how much an investment might fluctuate in value, investors should concentrate on whether an investment has a “reasoned probability” that it will not cause a loss of purchasing power over time. Buffett says stocks are the best way to preserve and increase purchasing power, while fixed income investments are not. According to Buffett, “A non-fluctuating asset can be laden with risk.”
In an article in Fortune adapted from Buffett’s annual shareholder letter, he laid out the argument against bonds and for stocks. Investments denominated in currency—bank deposits, bonds, money-market funds—are usually thought to be safe. “In truth they are among the most dangerous of assets,” Buffett writes. “Over the past century these instruments have destroyed the purchasing power of investors.”
How? It’s the twin effects of inflation and income taxes on interest. Buffett notes that it takes $7 today to buy the same goods and services that could be purchased for $1 in 1965. Currency-based investments pay interest rates that do not keep up with inflation once taxes are taken out of the interest. Thus, purchasing power falls. Today’s rates are very low and, “bonds should come with a warning label,” according to Buffett.
Those who want their capital to grow should invest in productive assets like businesses, farms or real estate. “Ideally these assets should have the ability in inflationary times to deliver output that will retain its purchasing power value,” Buffett says. The Dow Jones Industrial Average went from 66 to 11,497 during the 20th century, he adds. He says stocks will be the runaway winners in the future and “by far the safest.”
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