Whether through mutual funds or exchange-traded funds, index investing has become a popular system in the stock market over the past 50 years. Some of the most valuable insights can come from the best investors. In this article, we are delving into the wisdom of two legendary investors who have revolutionized the industry and demystified it for everyday investors. We’ll explore their prudent advice in their own words on leveraging index funds for retail investors, with a particular emphasis on the S&P 500, their views on cost considerations, and the nuances of long-term investing. Let’s discover how investors can apply their wisdom to guide their own financial journeys.
Warren Buffett’s Advice For Index Funds
Below is a transcript from a 2003 Berkshire Hathaway annual shareholder meeting.[1]
The questions posed to Warren Buffett and Charlie Munger are,” You said in a 1996 annual report that most investors will find that the best way to own common stocks is in an index fund that charges minimal fees. Two questions. First, there are a lot of different index funds that hold different baskets of stocks. What criteria would you use or recommend to select an appropriate index fund? Second, the price-to-earnings ratio of the S&P 500 is significantly higher than its historical average. What benchmark should an investor use in purchasing this index?”
Warren Buffett responded, “Yeah, I would say that in terms of the index fund, I would just take a very broad index. I would take the S&P 500 as long as I wasn’t putting all my money in at one time. If I were going to put money into an index fund in relatively equal amounts over a 20 or 30-year period, I would pick a fund. And I know Vanguard has very low costs. I’m sure there are a whole bunch of others too. I just haven’t looked at the field. But I would be very careful about the costs involved because all they’re doing for you is buying that index.”
“I think that the people who buy those index funds, on average, will get better results than the people that buy funds that have higher costs attached to them because it’s just a matter of math. If you have a very high percentage of funds being institutionally managed and a great many institutions charge a lot of money for doing it, and others charge a little, they’re going to get very similar gross results but different net results.”
“And I recommend to all of you reading John Bogle’s books. He’s written a couple of books in the last five years and they’re very good books. Anybody investing in funds should read those books before investing. Or, if you’ve already invested, you still should read the books. And it’s all you need to know really about fund investing.”
“So, I would pick a broad index but I wouldn’t toss a chunk in at any one time. I would do it over a period of time because the very nature of index funds is that you are saying, ‘I think America’s business is going to do well, reasonably well, over a long period of time. But I don’t know enough to pick the winners and I don’t know enough to pick the winning times.’ There’s nothing wrong with that. I don’t know enough to pick the winning times. Occasionally, I think I know enough to pick a winner, but not very often. And I certainly can’t pick winners by going down through the whole list and saying ‘This is a winner’ and ‘This isn’t’ and so on.”
“So, the important thing to do if you have an overall feeling that business is a reasonable place to have your money over a long period of time is to invest over a long period of time and not make any bet implicitly by putting a big chunk in at a given time.”
“As to the criteria as to when you should or shouldn’t, I don’t think there are any great criteria on that. I don’t think price-to-earnings ratio determines things. I don’t think price-to-book ratios, price-to-sales ratios, or any single metric I can give you, or that anyone else can give you in my view, will tell you ‘this is a great time to buy stocks’ or ‘not to buy stocks’ or anything of this sort. It just isn’t that easy. That’s why you go to an index fund. And that’s why you buy over a period of time. It isn’t that easy. You can’t get it by reading a magazine. You can’t get it by watching television. You can’t just have something that says ‘If PEs are 12 or below, you buy; if they’re 25 or above, you sell.’ It doesn’t work that way. It’s a more complex business than that. It couldn’t be that easy when you think about it.”
“So, if you are buying an index fund, you are protecting yourself against the fact that you don’t know the answers to those questions. But do you think you can do well over time without knowing the answers to those questions as long as you consciously recognize that fact? And you know, if you’re a young person and you intend to save a portion of your income over time, I just say, just pick out a very broad index. And I would probably use the S&P 500 because I think if you start getting beyond that, you start starting to think you should be in small caps this time and large caps that time or this kind of style. And as soon as you do that, you know, you’re in a game you don’t know. You’re not equipped to play in all candor. That would be my recommendation. Charlie,” Warren Buffet finishes his thoughts.
Charlie Munger responds, “I think his second worry is that common stocks could become so high priced that if you bought index funds, you wouldn’t expect to do very well. I didn’t think I’d live long enough to think that was likely to happen, but now I think that may happen.”
Buffett interjects, “But probably what you’re saying there is that they could get to a level and they’d have to be at a sustained level like that for a long time.”
Munger answers, “Be there and stay there for a long time.”
Buffett responds, “In which case you might make three or four percent. But would there be anything way better than that around under those circumstances anyway? And pass the peanut brittle, please.”
Charlie Munger continues, “Well, in Japan, where something like this happened, the return from owning a nice index over the last 13 years or so is negative. Can something as horrible as that happen here? I mean, is it conceivable? I think the answer is yes.”
Buffett interjects, “But the option in Japan, of course, is to have deposits in a bank or own Japanese bonds at somewhere between zero and one or one and a half percent. So if rates on everything get very low, which means stocks sell very high, then it just means that you live in a different world than existed 20 or 30 years ago when generally, capital got paid there.”
Key Takeaways
- Index funds, particularly those with low costs, provide a solid platform for investing in common stocks. This strategy is optimal due to its simple and broad exposure to the market.
- Regularly investing over a long period of time, rather than putting a large sum of money in at once, can help mitigate market risks.
- The S&P 500 is a reliable index choice because of its extensive and diverse market coverage.
- Careful consideration of costs is essential. Lower-cost funds generally provide superior returns due to the principle of compounding returns and reduced fee drag.
- No single metric, such as price-to-earnings ratio or price-to-book ratios, can determine the perfect time to buy stocks. Investing isn’t as easy as following a single indicator.
- Literature from renowned investors, like John Bogle, can provide insightful knowledge for fund investors.
- Maintaining awareness of one’s limitations in stock picking and market timing is key to successful investing.
- Current market conditions, including the possibility of low returns, should not deter long-term investing. Instead, they reinforce the need for consistent and disciplined investing.
Conclusion
Investing should be based on a long-term perspective, commitment to regular investments, and recognizing our limitations, this can guide us toward success. Index funds, especially those with low fees like the S&P 500, can serve as an efficient vehicle to achieve this. These funds simplify investing by providing broad market exposure and minimizing the need for stock picking or market timing. Investing should not be seen as a get-rich-quick scheme; instead, it’s a long-term commitment that requires consistency and patience. Above all, educating oneself through expert resources and knowing market conditions is indispensable in navigating the complex investment world. While market highs and lows may affect returns, long-term investors see these as part of the journey rather than deterrents. After all, investing is not about predicting the market perfectly but about participating sensibly and staying the course.