90/10 Strategy

What Is the 90/10 Strategy?

Legendary investor Warren Buffett invented the "90/10" investing strategy for the investment of retirement savings. The method includes conveying 90% of one's investment capital into stock-based index funds while allocating the remaining 10% of money toward lower-risk investments.

This system aims to generate higher yields in the overall portfolio over the long-term. Following this method, Buffett claims the potential gains an individual investor could achieve will be better compared than those investors who utilize high-expense investment managers. Notwithstanding, much relies upon the quality of the index funds the investor purchases.

How the 90/10 Strategy Works

A typical application of the 90/10 strategy includes the utilization of short-term Treasury Bills (T-Bills) for the 10%, fixed-income component of the portfolio. Investment of the remaining 90% is in higher-risk (but low-cost) index funds.

For example, an investor with a $100,000 portfolio electing to utilize a 90/10 strategy might invest $90,000 in a S&P 500 index fund. The remaining $10,000 might go toward one-year Treasury Bills, which in our hypothetical scenario yield 4% per annum.

Of course, the "90/10" rule is only a suggested benchmark, which may be easily modified to reflect a given investor's tolerance to investment risk. Investors with lower risk tolerance levels can adjust lower equity portions to the equation.

For instance, an investor who sits at the lower end of the risk spectrum may adopt a 40/60 or even 30/70 split model. The main requirement is that the investor earmarks the more substantial portion of the portfolio funds for safer investments, for example, shorter-term bonds that have a A-or better rating.

Calculating 90/10 Strategy Annual Returns

To calculate the returns on such a portfolio, the investor must multiply the allocation by the return and then add those results. Utilizing the example above, if the S&P 500 returns 10% at the finish of one year, the calculation is (0.90 x 10% + 0.10 x 4%) resulting in a 9.4% return.

In any case, assuming that the S&P 500 declines by 10%, the overall return on the portfolio after one year would be - 8.6% utilizing the calculation (0.90 x - 10% + 0.10 x 4%).

A benefit of index funds is that they have lower management fees than other funds because they are passively managed.

Real-World Example of 90/10 Strategy

Buffett not just advocates for the 90/10 plan in theory, but he actively puts this principle into practice as reported in Berkshire Hathaway's 2013 letter to shareholders. Most notably, Buffett involves the principle as a trust and estate planning directive for his better half, as laid out in his will:

My money, I ought to add, is where my mouth is: What I advise here is essentially identical to certain instructions I've laid in my will. One bequest gives that cash will be delivered to a trustee for my significant other's benefit. (I have to involve cash for individual bequests, because all of my Berkshire shares will be completely distributed to certain philanthropic organizations over the ten years following the closing of my estate.) My advice to the trustee couldn't be more simple: Put 10% of the cash in short-term government bonds and 90% in an extremely low-cost S&P 500 index fund. (I suggest Vanguard's.) I accept the trust's long-term results from this policy will be better than those attained by most investors — whether pension funds, institutions, or individuals — who utilize high-expense managers.

Special Considerations

There are variations of Buffett's 90/10 investing strategy that take into consideration the investor's age and risk tolerance. As an investor nears retirement, it's frequently really smart to rebalance a portfolio to reflect a more conservative approach toward investing. The investor's need to protect their nest egg so they have funds to live on during retirement becomes paramount over the requirement for continuous growth. Consequently, the percentages in the investment strategy might change considerably.

One approach has the investor switching the allocations so that 90% of funds are put in low-risk government bonds and 10% are invested in index funds. Additionally, investors who are bearish may opt for these allocation amounts as part of a crash protection strategy.

Other approaches change the percentages for each investment type contingent upon the investor's risk tolerance combined with other factors, for example, their craving to leave an estate to their heirs or the availability of other assets they can draw after during retirement.

Highlights

• The 90/10 investing rule is a suggested benchmark that investors can easily change to reflect their tolerance to investment risk.
• In a letter to Berkshire Hathaway shareholders, Warren Buffett outlines his plans to follow the 90/10 rule regarding his significant other's inheritance, which will be invested 90% in a S&P 500 index fund and 10% in government bonds.
• The 90/10 investing strategy for retirement savings includes allocating 90% of one's investment capital in low-cost S&P 500 index funds and the remaining 10% in short-term government bonds.