Warren Buffett is the third richest man in the world and has been hailed as one of the greatest stock pickers of all time. But you might be surprised the advice he is giving to his future heirs. Instead of investing in individual stocks or mutual funds, when Buffett passes away he wants his wealth placed in index funds.
“My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions, or individuals — who employ high-fee managers.”
Why does one of the greatest investors in the world believe that index funds are the best option for most people seeking to harness the power of the stock market?
As an investor you could purchase individual stocks. However, to pick the right stocks for your portfolio and avoid getting burned you’d have to do your research.
The stock picking pros at the highly regarded Motley Fool advise that you search for companies with a good business model and long term prospects. Make sure the company has long term growth prospects and is not overvalued. Finally, check that the company is being guided by competent and ethical leadership.
The problem is that researching all of this takes time and energy, which many of us simply do not have. Additionally, to diversify your risk, the Motley Fool experts suggest that you purchase and hold a minimum of 15 individual stocks.
Now that’s a lot of homework.
If you’re unable to put in that much effort, you can pay someone to do it for you. This is the idea behind managed mutual funds.
In a mutual fund a manager purchases a basket of stocks for the investor. The common belief is that a mutual fund manager will use his expertise to purchase the best bag of stocks for you, maximizing your returns. The truth, however, is that the numerous fees associated with actively managed mutual funds quickly devour your investment returns.
Which brings us to index funds.
Instead of trying to beat the market, which few individual investors or mutual fund managers are able to accomplish, index funds simply try to match market returns. With an index fund, you’re simply purchasing all the pieces of stock in a particular index. A S&P 500 index fund, for instance, would allow you to own a small piece of every one of the 500 largest companies in America. Because index funds are not actively managed, the costs associated with the funds are low, which helps maximize your profit.
Index funds do not carry the excitement associated with purchasing individual stocks or with dabbling with actively managed mutual funds. But in this case, boring can be beautiful because the returns generally are very close to the returns of the market overall. The S&P 500 has conservatively, on average, managed an annualized 7% return on investment over a period of multiple decades.
Warren Buffet is so sure that index funds are the key to unlocking the power of the stock market that nearly eight years ago he placed a one million dollar bet (with the proceeds going to charity). He wagered that a S&P 500 index fund would outperform a collection of hedge funds at the end of ten years. These hedge funds are similar in many respects to mutual funds and are run by some of the smartest investors in the industry.
Eight years into the bet and Buffett’s S&P 500 index fund has enjoyed a 65.7% return on investment vs only a 21.9% return for the hedge funds.
As Buffett summed up in a 2004 meeting:
“Among the various propositions offered to you, if you invested in a very low-cost index fund — where you don’t put the money in at one time, but average in over 10 years — you’ll do better than 90% of people who start investing at the same time.”
Clearly, when it comes to stocks, one of the best ways to invest is also the easiest. Simply place your money in a low-fee index fund.