“Don’t look for the needle in the haystack. Just buy the haystack!” John Bogle

Warren Buffett, the ‘ Oracle of Omaha’ and the world’s most successful investor, has recommended index funds as the best way for the average investor to generate wealth. In fact, he has instructed the trustee of his estate to invest in index funds.  “My advice to the trustee couldn’t 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,” he noted in Berkshire Hathaway’s 2013 annual letter to shareholders.

Buffett believes that the average American doesn’t have the time, knowledge, and desire to properly invest in individual stocks. Moreover, he has observed that most people don’t do a great job investing in individual stocks.

Also, Buffett feels that most actively managed mutual funds and hedge funds do a better job of compensating their managers than beating the market for their investors — especially over the long run.

The S&P 500 (also known as the Standard & Poor’s 500) is a stock index that consists of the stocks of 500 of the largest companies in the United States stock markets. The index is weighted by market capitalization, which means that larger companies make up a greater portion of the index’s value and therefore have more influence over its performance. The S&P 500 is considered by most experts to be the best indicator of how U.S. stocks in general are performing.

Passive investing is an investment strategy to maximize returns by minimizing buying and selling. Index investing in one common passive investing strategy whereby investors purchase a representative benchmark, such as the S&P 500 index, and hold it over a long time horizon.

— ur-trading (@urtrading) November 22, 2020

Over the past 90 years, the S&P 500 averaged around a 9.5% annualized return. Investing in the whole market with index funds offers consistent returns while minimizing the risks associated with individual stocks and other investments.

Bogle’s 8 Basic Rules of Investing

Simplicity is at the core of Bogle’s investment philosophy. In his famous book, “Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor,” he shares with readers his 8 basic rules of investing:

1. Select low-cost index funds
2. Consider carefully the added costs of advice
3. Do not overrate past fund performance
4. Use past performance to determine consistency and risk
5. Beware of stars (as in, star mutual fund managers)
6. Beware of asset size
7. Don’t own too many funds
8. Buy your fund portfolio – and hold it

Index funds have plenty of inherent advantages, such as:

They create instant diversification

• An index fund tracks a stock market index, such as the S&P 500, would usually hold all the stocks within these indexes.
• When you’re investing in hundreds or thousands of stocks at once, your portfolio is much more diversified than if you were investing in a handful of individual stocks. If you’re investing in an index fund that contains 500 stocks, one underperforming stock won’t have as much of an impact.

They’re more likely to bounce back from market downturns

• There are many different types of index funds out there. Some are broad market funds that mirror major market indexes, like the S&P 500. One major advantage of broad market funds is that they’re more likely to recover from market downturns.
• The S&P 500 has been around for almost a century, and during that time it has experienced countless corrections, downturns, and full-blown crashes. However, it’s always bounced back stronger than ever after each one. While there’s no way to know for sure what the market will do in the future, history shows us that if the market crashes again, the S&P 500 will very likely recover. And when your index funds mirror the S&P 500, that means your investments will bounce back as well.

They’re less expensive than other types of investments

• Index funds are passive investments, which means that they don’t have portfolio managers choosing which stocks to include in the fund. They simply track indexes, so they automatically include whichever stocks are in the index.
• Compared to actively managed mutual funds, index funds tend to be less expensive respect to fees. Actively managed funds do have someone choosing which stocks to include in the fund, and that results in higher fees.

In theory, actively managed funds should see higher gains than passive funds, because there’s an financial professional deliberately trying to improve the fund’s performance. However, in 2019, only 29% of actively managed U.S. stock funds outperformed their benchmarks, according to research from Morningstar. So not only are index funds less expensive than actively managed funds, but they tend to perform better, too.

Index funds are relatively low-risk investments, but they can also be less expensive than individual stocks and don’t require much management. Index funds are groups of stocks that track certain stock market indexes, such as the S&P 500. They’re considered passive investments because they simply mirror the indexes they track. In other words, there’s nobody deciding which stocks to include in the fund. This results in lower fees, often just a fraction of a percent of your total investments.

Compared to actively managed ETFs and mutual funds, index funds are generally more affordable. Although index funds are passive investments, they generally outperform their actively managed counterparts. And, a simple investment strategy in low-fee index funds is good enough for Warren Buffett, and it’s good enough for the average investor.

References:

1. https://www.thebalance.com/index-funds-wealthy-investors-reject-4142005#:~:text=Warren%20Buffett%20might%20be%20the%20world%E2%80%99s%20most%20famous,of%20his%20estate%20to%20invest%20in%20index%20funds.
2. https://www.thebalance.com/how-and-why-john-bogle-started-vanguard-2466413
3. https://www.fool.com/investing/2021/01/30/3-reasons-you-should-invest-in-index-funds-and-2-r/