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BACK IN 2010, at the Berkshire Hathaway annual meeting, a shareholder challenged Warren Buffett. Noting that shares of motorcycle maker Harley-Davidson had nearly tripled over the prior year, he asked Buffett why he had chosen to buy the company’s bonds rather than its stock. Buffett’s reply was a two-minute masterclass in how to think about investments. It’s worth walking through it point by point.
To start, Buffett acknowledged that hindsight can be cruel. “I might have asked the same question,” he said. But then he reminded the investor that we should never judge an investment decision solely based on its result. Instead, he emphasized the importance of a sound decision-making process. He then detailed how he thought about the Harley decision at the time.
Buffett started at a high level, with a discussion of asset allocation, and here he made a counterintuitive argument. Many of Berkshire Hathaway’s liabilities extended out more than 50 years, he said, and with such a long time horizon, it might seem like the company could afford to take an almost unlimited amount of risk in the stock market. Buffett acknowledged that was indeed the case. But, he said, “we would never have all our money in stocks,” even if, on paper, it seemed like the best choice.
Buffett and his partner, Charlie Munger, still chose to hold substantial amounts in bonds, even if that meant giving up potential gains. Why? Buffett went on to explain why holding bonds made sense even in the absence of any clear need. For starters, bonds provide flexibility during stock market downturns. And since bear markets always arrive without notice, and can last multiple years, it makes sense to hold bonds, more or less, at all times.
Perhaps not surprisingly, Buffett once mentioned that a trust he’d established for his family was similarly structured, with 10% in bonds, even though it had a long time horizon and could theoretically afford to be entirely in stocks.
Coming back to the Harley-Davidson decision, Buffett referenced his mentor, Benjamin Graham. In his book Security Analysis, he had explained the relative benefits of “junior” and “senior” securities. “Junior securities,” Buffett said, “usually do better, but you’re going to sleep better with the senior securities.”
What did he mean by junior and senior? In a typical corporate structure, where a company has issued both bonds and stocks, bondholders would have first claim on the company’s assets if it went into distress. Stockholders, on the other hand, would be further back in line. For that reason, bonds are said to be senior, while stocks are junior.
It’s an important distinction. Because of this structure, bonds are inherently more secure than stocks. They are essentially IOUs. But also because of that structure, bonds will normally have lower returns than stocks. Companies know they don’t have to offer as much in the way of interest to bondholders because of their more senior position. This is the technical reason why, all things being equal, bonds offer both lower risk and lower returns than stocks.
Buffett acknowledged that Harley-Davidson was a beloved company. “I kind of like a company where your customers tattoo your name on their chest.” Still, Buffett said, there were no guarantees. Even great companies can run into trouble. It was for this reason, Buffett said, that buying Harley-Davidson’s bonds was a relatively easy decision. “I knew enough to lend them money. I didn’t know enough to buy [the stock].” That’s because buying the stock would have required a much more detailed analysis of the motorcycle market, including an understanding of consumer trends and the effects of competition on Harley’s profit margins. Buying the company’s bonds, on the other hand, “was a very simple decision. It was just a question of, are they going to go broke or not?”
When we choose to buy bonds, in other words, we’re intentionally choosing the slow lane, but it’s for a reason: because bonds offer a level of certainty that stocks can never provide. And because of that certainty, we shouldn’t feel badly when bonds deliver meager returns. It’s by design.
Buffett wrapped up the discussion acknowledging that if he’d opted for Harley’s stock, he would have made far more money for Berkshire shareholders. But that wasn’t the right yardstick, he argued. “We are running this place so that it can stand anything.” That, I think, is the most important thing we can take away from this story. The investment industry spends a lot of time talking about performance—and specifically, about outperformance. Of course, we all want to see our investments grow, but what’s most important, in my view, is that your portfolio be resilient enough to “stand anything.”
One of the benefits of stock market downturns is that they give us an opportunity to stress test our emotional response to the market. After a roughly 10% downturn earlier this year, stocks are back at all-time highs, so this is a good time to take the temperature of your portfolio. If you lost some sleep during the downturn this spring, or the one we experienced last spring, this might be a good time to shift some of your portfolio to more senior, more secure, securities. If, on the other hand, you barely even noticed these downturns, that’s important information as well. Investing, in other words, isn’t just about numbers.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
