Warren Buffett’s advice: Buy shares in an index fund for the long-term

Over the past 50 years, Warren Buffett’s annual letters have attracted fans far beyond the shareholders of his company, Berkshire Hathaway.

Proto-Buffetts have long devoured the master’s words for insights into how he achieved an average return of around 20% a year for half a century – and perhaps to pick up a few stock tips, too.

But recently passive investors have also got in on the action.

Warren Buffett has repeatedly recommended index funds as the best solution for the average investor – whom he defines as nearly everybody, incidentally – but lately he’s become more strident.

Just last year Buffett revealed that when he passes away, the bulk of his wife’s estate would be placed into a single Vanguard index tracking fund, with the rest in government bonds.

And here on Monevator we covered how a UK investor can copy Buffett’s simple portfolio when it comes to index investing.

Buffett’s long-term case for investing in shares

In this year’s letter Buffett was more explicit still.

He didn’t just say you could buy via an index fund if you want to invest in equities1.

He said you should invest in equities via those index funds.

True, Buffett is explicitly talking about US equities.

But I think global equities amount to the same thing as far as his argument is concerned. (Besides, as I said the other day it’s important to beware of home bias robbing your returns as a UK investor).

Compared to cash or bonds, equities are clearly the place for long-term investors to be, says Buffett:

“The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities – Treasuries, for example – whose values have been tied to American currency.

That was also true in the preceding half-century, a period including the Great Depression and two world wars.

Investors should heed this history.

To one degree or another it is almost certain to be repeated during the next century.”

Of course most people have seen those long-term charts that show stock markets going up over the decades.

So why then do so many of us still horde our money in cash or bonds?

The answer is volatility – both the day-to-day fluctuations in share prices, and the ever-present risk of a stock market crash.

Buffett says:

“Stock prices will always be far more volatile than cash-equivalent holdings

Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions.”

Of course, you should always have some cash in an emergency fund.

You also shouldn’t be risking money that’s needed in the next 3-5 years in the stock market, given it’s propensity to crash when it’s least convenient.

But beyond that, says Buffett, the key is to distinguish between short-term risk caused by market fluctuations, and the long-term risk of inflation eroding the purchasing power of seemingly safer assets like cash or bonds – as well as the opportunity cost of missing out on the superior returns from shares.

Ignore the market noise

When investing in a pension over 30-40 years, for instance, I think it’s best to invest into an equity-heavy portfolio automatically year in, year out, and to try to ignore the news about the stock market – as opposed to holding a huge slug of safer assets to help you sleep at night while you obsessively track its value.

Buffett again:

“For the great majority of investors who can – and should – invest with a multi-decade horizon, quotational declines are unimportant.

Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime.

For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities.”

Fearful investors in 2008 and 2009 missed out on the buying opportunity of a lifetime, Buffett points out (assuming they didn’t do the only thing worse, which was to sell out of shares altogether and never get back in).

“If not for their fear of meaningless price volatility, these investors could have assured themselves of a good income for life by simply buying a very low-cost index fund whose dividends would trend upward over the years and whose principal would grow as well (with many ups and downs, to be sure).”

Easier said than done – but that’s exactly why you get a better return from shares than from sitting snug in cash.

The rewards come with risk.

Here’s what you shouldn’t do

Buffett’s laundry list of bad investing behaviour should be familiar to Monevator readers.

Investors are often their own worse enemies, he says, and they make putting money into the market riskier than it needs to be by turning short-term volatility into longer-term capital reduction through their antics.

Buffett highlights the following investing sins:

• Active trading

• Attempts to “time” market movements

• Inadequate diversification

• The payment of high and unnecessary fees to managers and advisors

• The use of borrowed money

All of these can “destroy the decent returns that a life-long owner of equities would otherwise enjoy” says Buffett, who adds that borrowing to invest is particularly risky given that “anything can happen anytime in markets”.

Obviously I agree with all this, but I don’t suppose Buffett will be any more successful than the rest of us in trying to make people understand that the fact that “anything can happen anytime in markets” is not a reason to avoid equities, but rather a reason to invest in a way that reflects this reality.

In other words, buy steadily and automatically over multiple decades to take advantage of the various dips and to enjoy long-term compounded returns.

Some friends who’ve been asking me about investing since our 20s – and getting the same advice on getting started from me – still begin these conversations with: “Is now a good time to invest?”

Nearly all would do far better never to think about it.

The trouble with active management

Similarly, here on Monevator I forever field questions from newcomers who think it is “obvious” that investing via the more skillful active managers is the way to better returns.

And indeed it would be if (a) the active managers did it for free, or very nearly so, and (b) you could pick those who outperformed in advance.

High fees crush the returns from active managers as a group, turning it into a worse-than zero sum game for active investors as a whole.

As for picking winners in advance, let’s just say many billions of pounds has been spent over the past 50 years trying to do exactly that.

Obviously some do succeed in some particular period, either through luck or judgement. But in terms of a demonstrable, repeatable process that we can use to reliably pick active funds that can overcome their fees and beat the market in advance – sorry, no bananas.

Hence passive investing – wrong as it feels – beats the majority of active investors. So why bother trying, when you don’t need to beat the market to achieve your goals?

But don’t take my word for it when we have one of greatest active investors of all-time on hand to say the same thing:

“Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades.

A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game.

There are a few investment managers, of course, who are very good – though in the short run, it’s difficult to determine whether a great record is due to luck or talent.

Most advisors, however, are far better at generating high fees than they are at generating high returns. In truth, their core competence is salesmanship.”

Instead of listening to their siren songs, says Buffett, investors – large and small – should instead read Jack Bogle’s The Little Book of Common Sense Investing.

Quoting Shakespeare:

“The fault, dear Brutus, is not in our stars, but in ourselves.”

1. Reminder: Equities is just a fancy word for ‘shares’. [↩]