FINANCIAL FRESHMAN #013
TL;DR → Warren Buffet once believed in index funds so much that he put a million dollars of his own money on the line. Index funds are a low-cost, self-cleansing, entirely passive way to invest in a diversified group of stocks. Depending on your specific situation and financial goals, index funds may make sense for you.
Warren’s Famous Bet
We’re all likely familiar with Warren Buffet—the chairman and CEO of Berkshire Hathaway, and 6th wealthiest person on Earth (at the time of this writing), with a net worth of $143.7 billion. He’s also an adamant supporter of index funds, and once put a million dollars on the line to prove their validity and value to the average American.
On December 19th, 2007, Buffet made a bet against Hedge Fund Manager Ted Seides of Protégé Partners. After a decade, Buffet wagered, a simple index fund tracking the S&P 500 would outperform any five funds that Protégé could hand-pick using their best advisors and investment analytics. The result? Buffet won, with his selected index fund growing 125.8% over this decade. He went on to share the complete results on page 11 of his 2017 letter to Berkshire Hathaway shareholders.
Buffett’s bet was a testament to the power of simplicity in investing. Index funds, like the one Buffett selected, offer everyday investors a straightforward, low-cost way to grow wealth without trying to outsmart the market. But what exactly are index funds, and why are they so effective? Let’s break it down in this beginner’s guide.
What is an Index?
To understand an index fund, it’s worthwhile to first explain a stock market index. An index, put simply, is anything that measures the performance of the entire, or a subset of, the stock market. Let’s speak to a few popular index examples.
- The Dow Jones Industrial Average – Tracks 30 prominent companies in the US, including Coca-Cola, Honeywell, and Nike.
- The Russell 3000 – Tracks the 3000 largest publicly traded companies in America.
- The S&P 500 – Tracks the 500 largest publicly traded companies in America.
For (just about) every stock market index, there is an index fund out there that can invest in it. VTSAX, Vanguard’s index fund that tracks the entirety of the stock market, is very similar to the fund that Buffet invested in for his bet (VFIAX).
Why Should You Consider Index Funds?
The overarching benefits of index funds can be outlined in four major points, presented here in no particular order.
Benefit #1 – They are Cheap
Index funds are known for their low expense ratios, meaning they have much lower fees compared to actively managed funds. Since they don’t require constant buying and selling of stocks by managers, the costs are kept down, allowing you to keep more of your returns over time. This cost-effectiveness is especially appealing for long-term investors.
Benefit #2 – They are Self-Cleansing
An index fund automatically adjusts as the market changes. As companies in the index rise or fall in value, the fund rebalances itself by following the rules of the index it tracks. For example, if a company in the S&P 500 underperforms and is replaced by a new one, the index fund will sell the old stock and buy the new one without any effort or decision-making from you.
Benefit #3 – They are Passive
Index funds are passively managed, meaning they don’t rely on frequent trading or attempts to time the market. This passive approach reduces the risks that come with active management, such as human error or poor decision-making, all while keeping costs low.
Benefit #4 – They are Diversified
When you invest in an index fund, you’re essentially buying a piece of every company within that index. This diversification spreads your investment risk across hundreds or even thousands of companies, rather than putting all your money in just a few stocks. It’s a built-in safety net because the performance of one company won’t drastically impact your overall investment.
These benefits, coupled with the long-term growth potential demonstrated by Buffet’s 2007 wager, reinforce index funds as an attractive investment choice.
Final Thoughts
An important note—any investment, including those in index funds, carries a degree of risk. Past performance is not a guarantee of future results, and it’s important to evaluate your financial goals and risk tolerance before making any investment decisions.
While index funds can be an excellent tool for building long-term wealth, it’s crucial to prioritize other key aspects of your financial plan. For many, investing in a 401(k) or Roth IRA should take precedence due to their tax advantages and potential employer matches. Once you’ve maximized those options, incorporating index funds into a broader investment strategy can help you diversify and grow your portfolio over time.
