I always make time to read Warren Buffett’s annual letter to his Berkshire Hathaway shareholders.
In contrast to the usual dry company reports, his letters read like a warm Buffett family Christmas newsletter, with a cast of familiar characters, recurring japes – and, okay, a fairly detailed description of how an insurance free float works.
And digesting the latest 2010 Berkshire letter with a nice glass of Australian Shiraz, I discovered a fabulous gem tucked amongst all the usual investing wisdom that surprised even a Buffett fanboy like me.
It was a modest letter within the main letter that Warren Buffett has republished, which was originally written by his grandfather, Ernest Buffett.
The Buffett family money gene
Anyone who has read The Snowball will know how Buffett’s early experiences and family life shaped his financial character.
But what this new Buffett letter reveals is that being careful with money – and feeling the urge to teach others how to shepherd it, too – runs deep in the Buffett family.
The letter was written in 1939 by Buffett’s grandfather Ernest, to his youngest son (and Buffett’s uncle) Fred, and his wife.
It reads (with idiosyncratic grammar) as follows:
Dear Fred & Catherine,
Over a period of a good many years I have known a great many people who at some time or another have suffered in various ways simply because they did not have ready cash. I have known people who have had to sacrifice some of their holdings in order to have money that was necessary to have at that time.
For a good many years your grandfather kept a certain amount of money where he could put his hands on it in very short notice.
For a number of years I have made it a point to keep a reserve, should some occasion come where I would need money quickly, without disturbing the money that I have in my business. There have been a couple of occasions when I found it very convenient to go to this fund.
Thus, I feel that everyone should have a reserve. I hope it never happens to you, but the chances are that some day you will need money, and need it badly, and with this thought in view, I started a fund by placing $200 in an envelope, with your name on it, when you were married. Each year I added something to it, until there is now $1000 in the fund.
Ten years have elapsed since you were married, and this fund is now completed.
It is my wish that you place this envelope in your safety deposit box, and keep it for the purpose that it was created for. Should the time come when you need part, I would suggest you use that you use as little as possible, and replace it as soon as possible.
You might feel that this should be invested and bring you an income. Forget it – the mental satisfaction of having $1000 laid away where you can put your hands on it it, is worth more than what interest it might bring, especially if you have the investment in something that you could not realize on quickly.
If in after years you feel this has been a good idea, you might repeat it with your own children.
For your information, I might mention that there has never been a Buffett who ever left a very large estate, but there has never been one that did not leave something. They never spent all they made, but always saved part of what they made, and it has all worked out pretty well.
This letter is being written at the expiration of ten years after you were married.
Ernest Buffett
“Dad”
Isn’t it great? I absolutely love this letter: I love the formality of it, the humility, I love the thought and the care of it.
Most of all I love the hard won wisdom in it.
This is a letter by a man who lived through the Wall Street Crash and the Great Depression. When Ernest Buffett says keep the money in cash in a deposit box where it’s easily accessible, he’s partly thinking about bank runs!
And when Grandpa Buffett says he knows people who have suffered from a lack of ready cash, he doesn’t mean that they couldn’t pop to IKEA to buy a sofa bed before the guests arrived. He means destitution in a world with no credit cards and few safety nets, save family.
In praise of cash
Buffett says that it’s this sort of Buffett family thinking that explains why Berkshire Hathaway customarily has at least $20 billion on hand.
That’s a lot of cash, and it’s held despite having the world’s greatest investor at the helm, who could be expected to make far higher returns on it than the measly percentage gains Berkshire will get on short-term deposit.
For you and I (who are still in the process of proving whether we’ll be the world’s latest greatest investors) there’s no debate – we should run hefty emergency funds and also keep a chunk of our portfolio in cash.
I love cash as an asset class. When people trash cash, warning me about inflation or telling me I should put more money into government bonds instead – or worst of all borrow to invest – my eyes genuinely glaze over.
Over the long-term the returns from gilts and cash aren’t so different, especially if you’re a private investor with a relatively modest nest egg who can chase the best savings deals. Yet the flexibility1 of cash is impossible to compare with bonds, let alone equities, REITS, or whatever else might take your fancy.
Having cash on hand means you don’t have to go into debt if the boiler blows up. Having cash in reserve means you can swoop to buy cheap securities in bear markets. It means some portion of your portfolio is as unblinking as a hungry Buffett sat before an out-sized hamburger.
In fact, I think new investors could do a lot worse than simply split their investing between a main market tracker and cash, and then forget about the other asset classes for a few years. The security of the cash is very helpful while you learn to stomach the volatility of shares.
Don’t get me wrong – I’m over 90% invested in equities. Cash has its place, but it’s little use in fighting inflation, and that’s the bane of long term investment.
But whatever you do, don’t bung cash overboard in your quest for future riches or even just a nice retirement. Cash cannot be beaten for liquidity and versatility.
Investing doesn’t end with a cash savings account, but that’s certainly where it starts – whether you’re in the Buffett family or not.
And finally…
Oh yeah, and let’s not forget this bit in the letter from Ernest:
I might mention that there has never been a Buffett who ever left a very large estate, but there has never been one that did not leave something. They never spent all they made, but always saved part of what they made, and it has all worked out pretty well.
That made me smile, too. It’s a Buffett family joke we can all share!
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It’s a lovely way of visualising the need for an emergency fund, though I’d assumed the safety deposit box was at a bank till you said he was hedging bank runs!
I find a couple of cash ISAs serve enough as my envelope – it’s enough of a pain to get the cash out of a cash ISA, so I have managed to fund modest emergencies out of dropping savings rather than hitting the EF. Though you have to keep topping the EF up as it is slowly being killed off by inflation, so I have a bog-standard savings account as well to lob the odd top-up, my aim is to keep it at about 10.2k in 2007 pounds. One of these days we may even get a tax-sheltered cash store that pays RPI 😉
Good old Grandpa Buffett for making it real, though I suspect he wasn’t alone in people of that generation who used to think that way. Some of my great-grandparents had similar views though they were on a different continent, indeed perhaps it was some of that thinking that built the West 😉
>> It’s a Buffett family joke we can all share!
Except his kids. He’s giving most of it away to the Bill and Melinda Gates Foundation isn’t he?
@Richard –Yep, although to be fair he (or at least his first wife?) gave them some BRK shares, from memory.
I totally applaud his approach to inheritance, too. The genetic lottery as he calls it is growing more, not less, iniquitous, within the developing world.
Cheers for stopping by!
NB $1,000 in 1939 is worth $15,000+ these days
There’s EFs and EFs. An EF for fixing the roof or replacing the car is a different beast from the one you need for bank runs. Different again is the cash you need for reinvesting after a bear market.
Each of these has different liquidity and size requirements. I think ERE says somewhere that a CC can do just as well as an EF as long as the credit limit is backed by a fungible asset somewhere.
Also, I have to say that 90% in equities is too scary for me!
@Salis — Absolutely, I have three levels of cash reserve and also very high credit limits across three credit cards should I need them. I don’t plan to!
Please help me on this. I like the idea of an emergency fund, but I don’t quite understand it.
I look at something like stock to be liquid. If I need the money, I just sell some stock. It’s right there for me.
I must be missing something. Or is an emergency fund something you want to get to within minutes or hours?
Thank you, I’m just a little confused. (And thanks for your blog;-)
@Mike Crosby
An emergency fund is cash.
Yes, you can sell some stocks if you wish, however, you probably paid some initial charges for the privilege of investing and also some charges to sell, not to mention any ongoing charges where applicable.
It doesn’t tend to be cost effective to start taking money out from such investments in the short term.
As a rule of thumb you should be prepared to invest in stocks for at least 5 years and that’s a minimum. Therefore, this doesn’t fit with the principle behind an emergency fund.
Another issue is liquidity problems. A good example is property funds in the UK that restrcited acces for up to six months back in 2008.
Let’s not forget investment risk. If your stocks take a fall and at the same time you need quick access to some money you wouldn’t want to further erode your stocks as you are diminishing the capacity to recover.
If you used a Financial Planner they would advise you to have an emergency fund before investing. You need to be in a position to invest before committing your money.
The big question is how much money do I need?
As a bare minimum 3 months expenditure but some say 6 months income or even 12 months. There is no exact figure.
@Thomas – Thanks for filling in those details Thomas!
@Mike – I would just add to what Thomas has alluded to by saying it’s a good idea never to *have* to sell a stock at a time that’s not of your choosing.
Stocks as you know are very volatile. Right now I look across my portfolio and see plenty of blue that I could top slice to raise cash if I needed it (which indeed I have been doing – to recycle into other investment opportunities).
But I well remember the deep bear market of 2008 and early 2009, and I’d have hated to have to sell holdings that were down 50% in the bear market just to raise cash because of some household or medical emergency. Not only would I be getting less money than I’d believe those companies were worth – believing them to be unjustifiably depressed due to fear and panic – but also my emergency fund would have dived with the market. That’s no good — a proper emergency fund helps you sleep at night!
Cash gives you opportunity to pay bills, consume without debt – and strike when you see a market panic, too, as Buffett did in the crash.
I have a different view – for every 10k I invest in stock I can add £ 650.00 to my annual wage through dividend yield. The dividends will also increase with (and hopefully above) inflation and I can compound them if I don’t need the cash, to increase my wage even more. Effectively my “emergency fund” is to put myself in a situation where I am comfortably earning more than I spend.
@compounder
Thats not an emergency fund, its just you adhering to the Micawber principle.
If some of that difference, say a years worth of salary, were kept in a highly liquid and non-volatile asset class (e.g. cash) then it would be an emergency fund.
If all of that difference was invested in stock and then your roof caved in just after the august market wobble you would have had to sell your assets at a 20% loss or had to take out a loan to cover the repairs.
At that point you would have become a lot clearer on what an emergency fund is.
Because I have accumulated enough income, which means that I earn significantly more than I spend, I have an emergency fund at the end of each month. Rather an earnings margin of safety than a lump sum.
Yes, you’re right, the market can decline, but I tend to drip-feed money in over time to mitigate the bumpy ride. I would rather not hold cash under the mattress, because in the same way there is market risk, there is opportunity cost risk, which increases with time as economies grow over the long term.
I am clear about what an emergency fund is; I suppose I would rather forgo the lump sum of an emergency fund for long term income.
sure – if you’re happy that one months savings is enough to cover unforeseen emergencies (e.g. a new motor, house repairs, losing your job etc.) then thats good (it implies a phenomenal salary 😉 )
an emergency fund could be thought of as an insurance policy (against anything) where the cost of your premium is the opportunity cost of not investing it in something that might give a better rate of return than cash.
sounds like you’ve thought it through and are happy that s enough
Yes, I think I’ve got my philosophy attuned to my circumstances. I am a poor consumer and wear the same shirts I bought 5 years ago. My car is a Mondeo I bought for £ 500.00, because a car doesn’t provide quality of life. My house is nice, because this is what provides quality of life, but I am not a slave to the mortgage, and it is fixed for 10 years so I know where I stand. I work hard, but from home, so if a tile slips from the roof I read a book on how to do repair it, and do it myself, in the same way I read Tim Hale’s book to learn how to view investing.
This formula makes me very happy indeed. I have an income from my investments which helps buffer any income shocks in my work, but if I have a good earnings year I put more in to my investments to increase my passive wage and my margin of safety. I am not rich and my actual net income is average – but I am free.
@Compounder — Thanks for your comments. Your strategy is similar to where I’ve edged towards in the past 2-3 years, mainly because I’ve been greedy for what I’ve seen as cheap equities and gone very, very overweight. It’s paid off handsomely so far, but it’s a risky strategy.
I still have about 3 months full expenses in ready cash, however, and more short-term liquidity beyond that if I need it. (NS&I certificates, which can be cashed in if need be though I’d rather not!)
The main danger of thinking of shares as your emergency fund is that you don’t ever want to be driven to sell shares for any reason other than you think the price is too high or there are better opportunities elsewhere. You don’t want to be dictated to sell by outside forces in other words.
Your job security and the stock market are probably somewhat correlated (recessions tend not to be great for shares!) so the risk you’re running is you find yourself out of an income, and forced to sell shares in a down market. Shares yielding 6.5%, as implied by your figures, are clearly at the riskier end of the spectrum, too, IMHO.
Clearly you’ve thought it all through and made your choice, but I thought I’d outline the above for any other readers tempted to follow your lead without giving all factors due consideration. 🙂
You’re right, it is a riskier strategy, and I would never want anyone to simply do as I do, and I have had my moments of luck to help me along. I bought high yielding investment trusts such as MRCH, HHI and HDIV when they were at significant discount to NAV during the start of the crisis. They could have gone lower, but they didn’t, and this has given me a good income foothold to compound and increase the yield. I get 9% on average and I think the same trusts still give 6 to 6.5%, so I buy a few if there is a discount to be had.
Obviously I am assuming this is the bottom of the earnings cycle, and my income will only get better from already quite high yields. However, I acknowledge that this is a brave assumption, and if it goes wrong it is something I will have to accept responsibility for, and the impact it will have on my life – back to corporate life!!
If it goes well, and trusts such as MRCH increase their payout (as they have done for years and years), then I can continue the life a lead, and am happy with.
Many thanks for your input.
C
@Compounder… Thanks for the further details, and glad you don’t feel put upon! 🙂
Regarding the earnings cycle, I think ‘bottom’ might be a bit optimistic! In the US both earnings from the S&P and GDP are both back to 2007 levels, and corporate profitability is at a record high on many measures. I happen to be in the camp that expects more to come is the better bet, but this isn’t a trough for sure.
But I’m with you on income investment trusts, which you may have seen me write about here several times before. I also remember the great days of income investment trusts trading at a discount. If you’re feeling nostalgic, I wrote about it at the time on Monevator.
http://monevator.com/2008/07/15/should-you-swap-your-shares-for-an-investment-trust-on-a-discount/
Interesting response and article. I think the market is expecting an 18% dividend increase in dividends this year, and this would be a result of companies from cutting costs and become leaner, more efficient entities. They can cut costs far quicker than governments can!
Anyway, my point is that over the last 3 years I have been buying equities at levels where dividends were re-based and have, and are due to be increased. I have also been buying equities at historically cheap prices – but only if there isn’t another earnings shock, of course!
Again, I reiterate that I am making some assumptions, and my logic could come back to bite me. However, I much prefer to buy in to a pessimistic market than an optimistic, frothy one.
I do not feel put upon. I have listened to you all, and I may accumulate some dividends for the purposes that have been outlined.
C
This is all very well, but what about a letter from a German grandfather, who experienced the hyperinflation of the Weimar Republic? Or an Argentine? The cash-envelopes sacrificed by those old men weren’t worth opening after ten years. Throughout much of the Second World War, cash was useless, since it was backed by states which were defeated, or unable to pay their bills.
It all depends on economic conditions, and one needs to be very aware of survivorship bias in these entertaining stories.