Here's the Investment Warren Buffett Thinks "Makes the Most Sense Practically All of the Time" | The Motley Fool (2024)

Don't you wish you could invest like Warren Buffett and get the kind of returns he does? Well, you can certainly invest in his company,Berkshire Hathaway (BRK.A 0.06%) (BRK.B 0.22%), and see your fortune grow along with his. He believes in the future of the company, of course, but he has also recommended another investment for most people: index funds.

Here's a closer look at why index funds are more exciting and powerful than you probably think they are. See if you end up wanting some shares of one in your portfolio.

Buffett on index funds

The title of this article is taken from a CNBC On the Money interviewwith Buffett conducted last year. In it, he suggested that investors "consistently buy anS&P 500low-cost index fund... I think it's the thing that makes the most sense practically all of the time."

It's far from the only time that he has recommended index funds, too. He has saidthat in his will, he offers these instructions for the money left for his wife: "Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard's.)"

Why, exactly, would Buffett push index funds? Well, in that 2017 CNBC interview, he added:

Keep buying it through thick and thin, and especially through thin... The temptation when you see bad headlines in newspapers is to say, "Well, maybe I should skip a year or something." Just keep buying... American business is going to do fine over time, so you know the investment universe is going to do very well.

His reason is Americaand his seemingly unshakable faith in its future. In his 2015 letterto shareholders, he said: "For 240 years it's been a terrible mistake to bet against America, and now is no time to start... America's golden goose of commerce and innovation will continue to lay more and larger eggs."

What are index funds?

So what, exactly, are index funds, and why would one invest in them beyond Buffett's urging? Well, they're passively managed mutual funds, as opposed to actively managed ones that have paid managers who research investment options and make buy and sell decisions regularly. An index fund is said to be passively managed because its managers don't do as much thinking -- or buying or selling. They just buy whatever is in the index that they aim to track, in the same proportion. If the index sheds some holding at some point, the index fund sheds it, too.

If you're invested in an index fund that tracks the S&P 500, such as the Vanguard 500 Index Fund (VFINX -0.65%), your money will be spread across those 500 companies (that happen to make up about 80%of the U.S. market), and you'll enjoy roughly the same performance as the S&P 500. The Vanguard Total Stock Market Fund (VTSMX -0.56%), meanwhile, encompasses all of the U.S. stock market, including small companies, while the Vanguard Total World Stock Index Fund (VTWSX) represents the world market. There are bond- and real-estate-focused index funds, too.

Why index funds?

Investing in index funds may sound more boring than investing in carefully chosen individual stocks or mutual funds, but these funds have a very solid track record. Overthe 15 years ending in June 2018, about 92% of U.S. large-cap stock mutual funds lagged the returns of the S&P 500. The pattern holds true for indexes of smaller companies, too. About 95% of U.S. mid-cap stock funds trailed the popular S&P MidCap 400 index over those 15 years, while the S&P SmallCap 600 index outperformed nearly 98% of all U.S. small-cap funds.

Part of the reason for their strong returns is their generally low fees. A typical managed stock mutual fund might carry an annual fee ("expense ratio") of 1% or 1.5% or more, while many broad-market index funds sport annual fees of less than 0.25% or even 0.10%. (There are some index funds charging more than 0.025%, but know that you usually have much better, lower-fee choices than those.)

It's important to appreciate just how much of a difference a single percentage point can make. So imagine two identical mutual funds, one with an annual fee of 1.1% and the other charging 0.1%. The table below shows how annual investments of $10,000 would grow, if they averaged returns of 10% annually, with those two fees subtracted:

Data calculations by author.

For the majority of us who don't have the time, energy, skills, or interest in becoming a hands-on active investor in carefully chosen individual companies or managed mutual funds, inexpensive broad-market index funds are perfect. Index fund investing is easy, cheap, and delivers returns that beat many more expensive alternatives. Plunk your money regularly into index funds and voila -- you're done.

Your money can grow powerfully even if it's simply tracking the growth of the overall market -- just like Buffett suggested it would. The stock market has averaged long-term annual gains of close to 10%, though over your investing period, you might achieve more -- or less. The table below shows how much you can accumulate at different growth rates when you make annual investments of $10,000:

Data calculationsby author.

How to invest in index funds

So how can you invest in index funds? Well, there's a good chance that your 401(k) plan at work includes some in its investment menu. Most major mutual fund companies offer index funds, too, so you can invest in them directly through the companies or through your brokerage if it offers the index funds you want. Many index funds also appear in the exchange-traded fund (ETF) format, where they trade like stocks but are essentially index funds.

Here are some index fund ETFs to consider:

• SPDR S&P 500 ETF
• Vanguard Total Stock Market ETF
• Vanguard Total World Stock ETF
• Total Bond Market ETF
• VanguardTotal Bond Market Index Fund
• Vanguard REIT Index Fund

Whichever index funds you choose, be sure to seek one with low fees, as there are very low fees to be found. A SPY share recently traded for about $275 per share, sported a dividend yield of around 1.85%, and chargedjust 0.09% in annual fees.

You may think to yourself that it's very nice that Buffett recommends index funds, but has he actually put his own money where his mouth is? Well, yes, he has -- through a famous 10-year, $1 million bet that recently concluded. (He won it, by the way, having bet that index funds would outperform hedge funds over a decade.)

When Warren Buffett offers investment advice, it's smart to learn from it, as he knows a thing or two about the topic. Fortunately, his advice about index funds is very easy to act on -- and it can reward you well over the long run, too.