Here’s Why Warren Buffett Recommends Investing in Index Funds

Whether you’re just out of college and looking to start your financial life on the right footing, or you’ve been investing for your retirement for years, renowned investor Warren Buffett says index funds are likely right for you. In a shareholder letter issued to Berkshire Hathaway shareholders in 2016, Buffett said:

“Over the years, I’ve often been asked for investment advice, and in the process of answering I’ve learned a good deal about human behavior. My regular recommendation has been a low-cost S&P 500 fund.”

The investing mogul was also quoted in a book titled “The Little Book of Common Sense Investing” as saying:

“A low-cost index fund is the most sensible equity investment for the great majority of investors. By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals.”

As you start investing, you hear time and time again that there is no such thing as a one-size-fits-all investment option. You hear that diversification is king and that you should consider working with a financial advisor to help you make wise decisions in the market.

On the other hand, one of the world’s most successful investors — and arguably the world’s most popular — says to throw all that hooey to the side. Instead, he says that you have the ability to generate gains that are better than those who say they can beat the market. All you need to do is pile your money into low-cost index funds — in particular, a low-cost S&P 500 fund.

But can that be right? Should you immediately go move your money into low-cost index funds? Well, that depends.

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What Are Index Funds?

Index funds are a kind of exchange-traded fund (ETF) or mutual fund. ETFs and mutual funds in general are pooled investments, offering investors a highly diversified opportunity to invest in a specific index, sector, or a wide range of other portfolio compositions.

When it comes to index funds, these funds’ portfolios are constructed specifically to mimic the action seen in the underlying index. To do so, index funds purchase shares of every stock listed in a particular index and weight them according to the index weighting. As a result, index funds have a strong correlation with the underlying index they represent.

These funds offer investors access to a highly diversified portfolio with minimal fees. Instead of paying transaction fees on the purchase and sale of thousands of shares of stock, with index funds investors have the ability to own every asset in an underlying index with a single trade.

Index Funds Are Not All Created Equal

Although all S&P 500 index funds are composed of the same component stocks that comprise the S&P 500, not all index funds are created equal. In particular, fund managers are providing a service, and they value their services differently.

According to Investopedia, the average expense ratio for actively managed mutual funds ranges between 0.5% and 1.0%. However, these fees can climb as high as 2.5%. When it comes to passive index funds, the average expense ratio is 0.2%.

The difference between a fee of 0.2% and 2.5% may not seem like much, but when you factor in compound growth over the long run, that’s a massive difference. An investigation by NerdWallet found that a 25-year-old investor who had $25,000 to invest and an additional $10,000 per year with a 7% average annual return would lose more than $500,000 in long-term value after 40 years for every 1% in additional fees paid.

So, with a range between 0.2% and 2.5%, the difference in fees over the course of a 40-year investment could be more than $1 million. Now that 2.3% difference in fees seems like the difference between a bicycle and a Ferrari — they’re simply incomparable.

As a result, when choosing an index fund to invest in, it’s important that you pay close attention to the expense ratio involved.

In both Warren Buffett quotes above, the investing guru suggests that investors should invest in low-cost index funds. I’m sure if you heard him say it, there would be a strong emphasis in his voice when he uttered the words “low-cost.”

Index Fund Returns Compared to the Pros

Not surprisingly, there seems to be quite a bit of truth behind the statements Buffett has been making with regard to low-cost index funds. The idea behind his recommendation is that the cost of bringing in investing professionals to manage a fund or portfolio outweighs the benefits.

He goes on to explain that, even though you’re paying additional fees for an expert to pick your investments for you, your portfolio will rarely beat the market.

Is that really true? Are financial advisors and hedge-fund managers making a killing by providing little to no value to the average investor? Seemingly so.

In an S&P Dow Jones Indices report released in 2019 and reported by CNBC, the performance of index funds was compared head-to-head against the performance of active fund managers.

The report found that, for the ninth consecutive year, performance among the majority of hedge funds lagged the performance of the S&P 500 index. The report looked at returns across small-cap, mid-cap, and large-cap funds, finding that the vast majority of them missed the mark.

Small-Cap: 85.7% of small-cap funds trailed the S&P 500 in the 10 years leading up to 2019.
Mid-Cap: 88% of mid-cap funds underperformed compared to the S&P 500’s performance over the 10 years leading to 2019.
Large-Cap: 85.1% of large-cap funds lagged the S&P 500 in the 10 years leading up to 2019.

As you can see, there are some funds that do outpace the S&P 500. However, the vast majority of them miss the mark, suggesting that Warren Buffett is onto something when he advises investors to stick to low-cost index funds.

Index Fund Pros and Cons

No matter what investment vehicle you’re looking into, it will come with its fair share of pros and cons. Although index funds are Warren Buffett’s darling and have plenty of perks, there are also some drawbacks that you should consider when investing in them.

Pros of Index Fund Investing

There are several reasons why index funds — in particular low-cost index funds — have a place in just about anyone’s investment portfolio. Some of the most interesting perks associated with these types of investments include:

1. Diversification

Diversification is an important part of just about any investment strategy. By spreading your investment dollars across several stocks or other assets, you greatly reduce your risk of taking on significant losses should one of your investments take a dive.

Index funds are naturally diversified investments. When you purchase an S&P 500 index fund, you’re buying an interest in every one of the 500 stocks listed on the index. Even the most highly diversified portfolios don’t generally have 500 different assets under management.

This high level of diversification means that your portfolio won’t be at the mercy of any single stock or small group of stocks.

2. Stable Growth

It’s true — even the largest of the benchmark indexes in the United States will see declines from time to time. In some cases, these declines can be extreme and last for months or even years. Over the long run, however, indexes in the United States have a strong history of providing relatively stable growth.

For example, over the past 90 years, the S&P 500 has generated returns of 9.8% annually on average. Similar rates of growth have been experienced across the Dow Jones Industrial Average and the Nasdaq. Considering the long-term stable growth seen in United States indexes, it’s hard to argue against investing in them.

3. Low Cost

When compared to investing in individual stocks, most index funds will come with a substantially lower cost. That’s especially the case when it comes to the comparison between index funds and an actively managed portfolio of individually chosen stocks or mutual funds.

The reason is simple. When you purchase an index fund, you receive a high level of diversification while making a single trade, greatly reducing your transaction costs and management fees. Because of the impact these fees have on your long-run returns, the low cost associated with index funds can be overwhelmingly appealing.

4. No Experience Required

Index funds are generally low-cost investments that come with high levels of diversification. They are known for stable growth, and often have returns that beat all but the most successful of Wall Street’s hedge funds. And you don’t need to have any experience to invest in them.

As Warren Buffett has said time and time again, index funds are one of the most sensible investments that can be made, and it doesn’t take a rocket scientist to buy them.

The key to purchasing index funds is simply to pick an index you’re interested in and pay attention to the costs associated with an investment. From there, all the investor needs to do is let the fund do what it does, and chances are that the long-term return will be impressive.

Cons of Index Fund Investing

So far, index funds may seem like butterflies and rainbows. What could be wrong with these stable, long-term investments? As the band Poison cautioned rock lovers in 1988, every rose has its thorns.

Here are the drawbacks you should consider before investing in an index fund.

1. Overly Diversified

When you purchase an index fund, you’re purchasing every asset within the underlying index. That comes with its benefits, but also comes with a big drawback. Extensive diversification means that your portfolio will likely be influenced by hundreds of assets.

That’s quite a bit to follow.

Some experts argue that diversification should be limited to the number of investments that you have the time to properly track and research. With hundreds of assets included in many index funds, there’s no way any single investor could properly track and understand everything that’s going on.

2. No Control

It’s also worth considering that index funds ultimately take control of your investing dollars out of your hands. When making these investments, you’re not only investing in the top-performing stocks within an index, you’re investing in the worst-performing stocks in the index.

Although some investors find solace in the safety that this level of diversification provides, others simply don’t like the fact that they have no ability to ditch the worst-performing assets within their portfolios.

3. Index Funds Are Cyclical

Cyclical investments are those that have a strong correlation with the United States economy, and index funds are about as cyclical as they get. This means that when economic conditions are positive, these investments generally yield strong gains. Conversely, when economic conditions are negative, index funds tend to see declines.

While buying and holding index funds for the long run will generate strong average annual returns, when economic conditions are poor, your portfolio may experience extreme losses.

4. You’ll Never Beat the Market

Finally, it’s impossible to beat the market when you mirror the market. If you’re invested in index funds entirely, your portfolio closely tracks the market’s performance. So, while you can expect to see strong, long-run returns, you simply can’t expect to beat the returns experienced in the overall market.

How Much Should You Invest in Index Funds?

All in all, index funds seem to be a great investment, but should 100% of your portfolio be invested in them? Not necessarily. There are a few factors that you’ll want to take into consideration when deciding how much of your investing dollars you’re going to dump into index funds.

Your Investing Style

Index funds are best for the buy-and-hold investor. These investors are looking for long-term returns with relatively stable growth. If you’re an investor interested in active investing in which higher levels of risk are taken through short-term investments in an attempt to beat the market with momentum plays, this isn’t the investment for you.

Your Understanding of the Market

Index funds are great investment options for newcomers to the investing community who don’t quite understand how to analyze a stock and make effective investment decisions.

Because index funds give relatively safe access to the market while generating strong average annual returns, they offer a great entry point for novices.

Economic Conditions

Even if it seems like index funds are a perfect fit for you, you should take economic conditions into account before making your investment. Keep in mind that index funds are cyclical investment options that will generally experience declines during times of tough economic conditions.

As a result, you are likely to get better results investing in index funds when economic conditions are positive. Should economic conditions prove to be negative, you should consider looking for some noncyclical investment options.

It’s also important to take the time to review economic conditions at least on a quarterly basis when investing in index funds. Should there be any insinuation that the United States economy is going to take a dip, it’s a wise idea to trim your positions in any index funds you are invested in and look for safe-haven investment opportunities.

Final Word

Warren Buffet has long been a proponent of low-cost index funds, and for good reason. Over the years, these funds have proven to outpace the returns of some of the best-known fund managers on Wall Street. At the same time, they come with low costs that could mean millions of dollars’ difference in the end result of your investments.

Nonetheless, index funds also have their drawbacks. The overdiversification, lack of control, and cyclical nature of index funds are a turn-off for some investors. Not to mention, it’s hard for some investors to accept that their investments in index funds will never beat the returns seen from the overall market.

All in all, index funds are a great choice for the novice investor or the buy-and-hold investor. However, if you want more control, have a higher appetite for risk, and crave the potential to beat overall market returns, index funds may not be right for you.