Warren Buffett: The 'terrible mistake' investors should avoid

Warren Buffett, the world's most closely watched investor, has warned that it is a "terrible mistake" for long-term investors to measure risk by a portfolio's ratio of bonds to equities.

His comments come following the 35-year bull run for bond markets, which has sent yields tumbling to historically low levels.

High quality bonds, including those issued by governments in the US and the UK, have seen the highest levels of demand, causing prices to rise and yields to fall. For some time now the yield available on short dated paper, including 10-year UK government bonds, has been lower than the average yield on the FTSE 100 index, something that historically has not been the case.

Similarly, the level of income available on the perceived safest US bonds falls short of the average yield on the S&P 500 index.

Against this backdrop low-yielding bonds are a "dumb" investment relative to equities, claimed Buffett, in his latest shareholder letter. The Sage of Omaha adds that it is also a mistake to view bonds as safer than equities.

In the past, as a rule of thumb, a 50% weighing to shares and 50% stake in bonds was considered the ingredients of a 'balanced portfolio', but given that bonds have become riskier to hold Buffett argues it is a mistake to judge risk in this way.

"In any upcoming day, week or even year, stocks will be riskier - far riskier - than short-term US bonds. As an investor's investment horizon lengthens, however, a diversified portfolio of US equities becomes progressively less risky than bonds, assuming that the stocks are purchased at a sensible multiple of earnings relative to then-prevailing interest rates."

He adds: "It is a terrible mistake for investors with long-term horizons - among them, pension funds, college endowments and savings-minded individuals - to measure their investment "risk" by their portfolio's ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk."

Monetary policy has supported bond markets for a decade, but last year this started to reverse, as interest rates went up in the UK and the US. At the same time inflation began to rear its ugly head. Inflation is a bond's worst enemy, as it erodes the purchasing power of the income investors are paid. When inflation returns, holders of long-dated bonds will suffer the most.

Despite bonds becoming a less attractive proposition on paper - bond funds proved more popular than equity funds in 2017. Experts put this down to investors' growing scepticism of the strong run equity markets have largely enjoyed over the past eight years, which has been dubbed by many as the most hated bull market in history.