“The goal of the non-professional 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.”
Who said this? Was it a financial talking head? A coworker? Your uncle, boasting about his wealth after a few glasses of Christmas eggnog? In fact, this is Warren Buffett writing to his shareholders in his 2013 letter. He goes on to say that he will follow his own advice with his estate. Meaning that Warren Buffet, the country’s most famous investor, will not be entrusting his money to even the most well regarded investment company when he dies. Instead he is going to put 90% of this cash into an S&P 500 index fund and 10% into government bonds.
A quote like this should immediately get us out of the stock picking game. By saying it, Buffett is formally endorsing what investors and academics have been saying for decades: don’t try to time the market, don’t buy individual stocks, and instead purchase diverse index funds with an emphasis on low fees.
But why the obsession with index funds? Well, first it’s important to know what an index is. The Dow Jones Industrial Average and the S&P 500 are examples of indices, and they are just groups of stocks. The S&P 500, for example, is composed of the 500 largest American companies by market capitalization. When we buy an S&P 500 index fund, we’re buying a basket of stocks that matches that index. That’s why the fees are so low.
Think of how easy this is for the investment company. There’s no analysis of stocks by highly paid experts. Instead a program tracks a group of stocks that someone else already selected. As an extra bonus, diversity is baked right into the product, as no one company’s troubles will wipe out a nest egg.
But why are fees so important? Well, as non-professional investors, fees are the only aspect we have full control over. A good rule of thumb is that if fees on investments hover around 1%, they are likely too expensive. As a comparison, the fees on most Vanguard index funds range from .15% to .35%. No rational consumer would pay six times more for cable than their neighbor, but that’s exactly what’s happening when they invest in high fee investments. Over time, these fees add up to tens of thousands of dollars (or more) and can actually push back financial independence (and isn’t that the whole point?
Here’s where the common sense person starts to itch. This surely is too easy to be true, they think. Spending more money on, say, my work boots gets me a superior product – shouldn’t investing work the same way? But fortunately for the common investor, the data does not show that high fee, “actively managed” funds do any better over time than index funds. Superstar funds can beat the market occasionally, but not consistently. The only true consistency is their fees, which are charged equally in good years and in bad.
The only thing we lose by investing in low fee index funds is the ability to brag about our stocks as if they were fish we caught (I bought it this low!). Sadly, low fees do not make for riveting dinner conversation. But if someone does ask, just say you’re investing like Warren Buffett. I guarantee it will get their attention.
The views expressed represent the opinion of the author and are not intended to reflect those of FutureAdvisor and are not intended as a forecast, a guarantee of future results, investment recommendations or an offer to buy or sell securities.