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Warren Buffett’s most personal bet yet on index fund investing

Warren Buffett is buying index funds

The world’s greatest investor, Warren Buffett, has often shared his thoughts on investing in index funds over the years.

And – perhaps surprisingly – he’s a mad fan of index tracker funds.

I say surprisingly, because Buffett has one of the best long-term records of any active manager ever.

Buffett’s superlative record of very nearly 20% annual returns a year since the 1960s has been achieved even as the money he manages has grown from its spare bedroom hedge fund beginnings into the vast $280 billion Berkshire Hathaway vehicle he runs today.

So if anyone deserves to strut about saying index investing is for idiots and active management is the way to go, it’s Buffett.

But he says the complete opposite.

Buffett says buy the whole buffet

In his 2014 letter to his shareholders, Warren Buffett has come out more explicitly than ever as index investing’s richest champion.

Buffett writes:

In aggregate, American business has done wonderfully over time and will continue to do so (though, most assuredly, in unpredictable fits and starts).

In the 20th century, the Dow Jones industrial index advanced from 66 to 11,497, paying a rising stream of dividends to boot. The 21st century will witness further gains, almost certain to be substantial.

The goal of the nonprofessional should not be to pick winners — neither he nor his “helpers” can do that — but should rather be to own a cross section of businesses that in aggregate are bound to do well.

A low-cost S&P 500 index fund will achieve this goal.

Buffett even reveals that the cash he is leaving his wife in his will1 is to be invested in bonds and a Vanguard index fund:

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.

Still think a very simple asset allocation is beneath you?

Admittedly Buffett has gone one step further in his will than I’d suggest is appropriate for most of us. He will invest all of his wife’s money in the US, and so eschew the benefits of investing overseas.

But remember that this will be a legacy for his wife, who is already in her late 60s. By investing for her entirely in America, Buffett sidesteps any worries about currency risk, which can be more of an issue when you’ve fewer years for your investing to play out.

And after several decades of urging his fellow countrymen to Buy America, it’s no surprise Buffett thinks it will do fine for a couple more decades after he’s gone.

Know nothing. Invest wisely. Retire richer.

As well as making the case for index funds, Buffett’s new letter stresses that your behaviour as an investor is just as important as how you invest.

To illustrate, he revives the late Barton Biggs’ quip about bull markets:

 “A bull market is like sex. It feels best just before it ends.”

Buffett says the main danger is that the timid or beginning investor will enter the market at a time of extreme exuberance and give up when he loses money. (The unfortunate opposite of buying more heavily in bear markets).

He argues:

The antidote to that kind of mistiming is for an investor to accumulate shares over a long period and never sell when the news is bad and stocks are well off their highs.

Following those rules, the “know-nothing” investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results.

Indeed, the unsophisticated investor who is realistic about his shortcomings is likely to obtain better long-term results than the knowledgeable professional who is blind to even a single weakness.

To back up his case that a “know-nothing” investor can do fine with buy and hold, Buffett cites a farm he acquired in the 1980s, and also an investment he made in a New York apartment block in the early ’90s.

Buffett is no farmer, and having lived in the same house since the 1950s he’s clearly not obsessed with property, either.

Yet his farm has gone up five-fold since he bought – despite him only visiting it once – and his apartment block has paid out 150% of what he put in over the years as it’s been refinanced at lower interest rates, whilst annual dividends now exceed 35% of the initial investment!

He’s yet to visit the apartment.

My two purchases were made in 1986 and 1993. What the economy, interest rates, or the stock market might do in the years immediately following — 1987 and 1994 — was of no importance to me in determining the success of those investments.

I can’t remember what the headlines or pundits were saying at the time.

Whatever the chatter, corn would keep growing in Nebraska and tenants would flock to New York.

So Buffett bought and held.

Buy index funds

Of course, you might say Buffett’s promotion of index funds is just the ultimate in grandstanding for his own abilities as an active investor.

After all, he isn’t selling Berkshire’s assets to pump hundreds of billions into an S&P tracker fund. And he’s not suggested his shareholders swap their Berkshire stock for Vanguard index funds, either.

“Invest with me or give up!” would be a cynical summary of Buffett’s message.

Too cynical, I think. The fact is Buffett has long given great tips to anyone wondering how to invest their money, and he knows as well as anybody that the vast majority who choose to use active mangers will be disappointed.

He’s even in the middle of (almost certainly) winning a $1 million bet with a hedge fund manager, wagering index funds will beat the latter’s chosen hedge funds over ten years.

To conclude, I’ll paraphrase his famous rallying cry when the stock market crashed in 2008 and despair reigned:

Buy index funds. Buffett is.

  1. Buffett has to donate cash to provide such specific bequests, because most of his wealth is in Berkshire stock that is pledged mainly to Bill Gates’ charity. []

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{ 21 comments… add one and remember nothing here is personal advice }
  • 1 mistersquirrel February 27, 2014, 4:06 pm

    For most people I agree: passive trackers are the way to go and that’s certainly the strategy I pursue and recommend to friends. Interestingly, if this Reuters [http://uk.reuters.com/article/2014/02/17/uk-financial-etf-growth-idUKLNEA1G00C20140217] article is true, then passive funds make up just a little over 20% of the total market.

    So that still means most people are chasing after actively managed funds. There’s presumably a point though if more than x% of funds are simple trackers where nothing would actually move?! I wonder if anyone has done any research into this.

  • 2 MacroVal February 27, 2014, 5:00 pm

    A fund manager advocating transfer of private wealth into funds? I thought I’d heard it all.

  • 3 ermine February 27, 2014, 5:07 pm

    > Buy index funds. Buffett is.

    I know I really shouldn’t highlight this, but – ahem, cough 🙂

  • 4 neverland February 27, 2014, 5:57 pm

    Hmm well as far as askewing overseas investment goes the US market is a very much more widely diversified beast than the UK

  • 5 jon February 27, 2014, 7:06 pm

    Index funds are the way to go for most people. However, what do you actually do when you come to retire ? if you got $50bn you can sell a small chunk every year with little chance of all your capital depleting before you pop your clogs.

    That’s why I focus on income passively as possible: HYP (never sell unless forced), dividend and corporate bond ETFs (track indexes passively). The benefits of seeing dividends and coupons deposited into your brokerage account every week should not be underestimated and gives you motivation to stick to your plan. Passive investment may not generate obvious benefits immediately and hence people may not stick to it long term.

  • 6 The Investor February 27, 2014, 7:13 pm

    @ermine — That article also says most people should invest in tracker funds. There’s no big secret to unveil, I think I’ve been quite consistent about that for 5-6 years on Monevator. Believe me it’d be more interesting, popular, and likely lucrative to focus on active investing, but it’s not the right course for most.

    [I’ve deleted my longer original reply here as it was even more tedious to read than to write!]

  • 7 ermine February 27, 2014, 9:52 pm

    @TI sorry, I was just being mischievous – the message is delivered consistently IMO 😉

    @Jon interesting that you consider a HYP as passive. I agree with the don’t sell mantra, but I’m not sure the approach can be described as passive?

  • 8 The Investor February 28, 2014, 1:08 am

    @ermine — No worries. Excuse the terseness, long day. 🙂

  • 9 Jon February 28, 2014, 10:58 am

    @ermine – HYP I would say is semi-passive. Only going down this income route so that I don’t have to wait until 55. I’m in the process of converting my SIPP into the most passive strategy possible. 50% in VWRL (Vanguard Global Stock ETF), 50% in IGLO (I shares Global government bonds), rebalance annually and just leave it there until I hit 55.

  • 10 Dave February 28, 2014, 3:40 pm

    Buffett’s performance seemed to have dipped over the past decade or so. Perhaps because he has lost it, the market is tougher to beat or he is too large to be much more than a closet tracker.

  • 11 theFIREstarter March 3, 2014, 9:26 am

    In the Richard Buxton article:

    “It suggested picking shares by market captialisation was the worst of all options. Ten million randomly picked portfolios performed better over four decades, once the risk taken was considered, than an index based on the size of the companies included on it, which is how tracker funds select shares.”

    Surely this can’t be true!?

  • 12 The Investor March 3, 2014, 11:09 am

    @theFIREstarter — The essence is true (I forget the exact numbers) but the inferences are more subtle than Buxton allows:

    http://monevator.com/why-market-cap-investing-still-works/

    A big reason why the Monkey-Folios do better is that such random portfolios get a lot more small cap shares, and small cap shares outperform over the long-term.

    The other thing to remember is this is just chaff thrown up by a fund manager to distract us.

    Trackers beat 90% (or similar) of active funds over 3-5 years, after costs (indeed *because* of costs).

    So however “bad” trackers are, investing in an active fund is — from an expectations perspective — even worse.

  • 13 Justin @ Root of Good March 3, 2014, 7:55 pm

    I latched on to index funds pretty early on in my investing career. Then I read that Warren Buffett was a huge fan of index funds, too. If Buffett is good with index funds, then I’m feeling pretty smart, too.

    They won’t ever make me a billionaire, but I’m happy enough with the results I received.

  • 14 theFIREstarter March 4, 2014, 10:46 am

    @TI – Thanks for the reply! Makes perfect sense.

    I am presuming in those randomly picked Monkey-folios they do not add an actively managed fund cost into account (because there are none, seeing as they are “made up”)? Or if they are factoring in costs I am presuming it is only trading costs (which are fairly insignificant compared to the size of their imaginary funds, again I am guessing)?

    As I then thought what is stopping me from running a random Monkey portfolio in real life and beating the index, a near guarantee according to this study, but I am guessing that trading costs will kill me very quickly due to the amount of buys/sells to the size of my funds!

    It seemed to me like there were a lot of bold and sweeping statements made by Buxton in that article, it stunk of BS. Chaff thrown up to distract us summarizes it very well I think!

  • 15 @freepursue March 5, 2014, 5:13 pm

    Time and time again, the proof reinforces the statement:

    Following sound investing practices is NOT sexy.

    Period.

    So is living debt-free and within your means (because no one has their net worth pasted on their forehead at any given time).

    Suck it up. It’s the way it is. And, when you do decide to live that way, you find out it’s the best kept secret. Shhh….

  • 16 Pura Vida Nick March 5, 2014, 11:16 pm

    Warren Buffett is so fascinating because not only is he the greatest investor of all time, but he has so much emotional intelligence to go with his intellectual intelligence. The man can explain things in such understandable terms.

  • 17 ivanopinion March 14, 2014, 6:54 pm

    An interesting article in The Economist on this:
    http://www.economist.com/news/finance-and-economics/21596965-costs-actively-managed-funds-are-higher-most-investors-realise-against

    (apologies if it is already posted somewhere on the site)

  • 18 The Investor March 14, 2014, 8:34 pm

    @ivanopinion — No worries, but I did have it in Weekend Reading the other week. 🙂

  • 19 ivanopinion March 15, 2014, 1:51 pm

    @TI

    I imagined you would, but there’s no search box for the site, so not always easy to find. 🙂

  • 20 The Investor March 15, 2014, 1:55 pm

    Search box in right hand sidebar. I know it needs to move higher! 🙂

  • 21 ivanopinion March 15, 2014, 2:03 pm

    Ah!

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