How much would you pay to get a one-on-one meeting with the best stock picker in living memory and ask him for advice on how to invest for your retirement?
You could try to win the annual power lunch with Warren Buffett offered annually by the Glide Foundation. The winning bid of the 2014 auction, held on Ebay, was made by Andy Chua from Singapore who was willing to pay $2,166,766 for the privilege. I wouldn’t recommend doing this if inside information is your goal. Diners are forbidden from asking Mr. Buffett for investment tips.
Don’t have millions to spend on lunch?
The good news is you don’t have to pay a dime for Mr. Buffet’s valuable advice. Warren Buffett published the instructions he has left to the trustee who will manage his wife’s trust in a letter to Berkshire investors. The instructions could fit on the back of an envelope and couldn’t be easier to follow.
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. (VFINX))
Following Mr. Buffett’s advice is as easy as visiting Vanguard’s website (or any other investment company with low cost index funds) and transferring your savings to a new account. Vanguard’s VFINX index fund will only cost you 0.17% of your savings a year in fees.
Although only a sentence long, Mr. Buffett’s advice raises a lot of questions.
Why Invest in an S&P Index Fund And Not In Berkshire Hathaway Stocks?
Wait a second, isn’t Warren Buffett the CEO of Berkshire Hathaway? Is he actually saying his own company is a bad investment and that stockholders would be better off investing in a Standard & Poor’s index fund? Well, yes and no.
It’s not that Berkshire Hathaway is a bad investment, quite the opposite. Berkshire is one of the few companies that has consistently outperformed the S&P index in the last 50 years. If you had invested $1,000 in Berkshire Hathaway in 1965, when Mr. Buffett took control of the company, you would be a multimillionaire today.
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From 1965 to 2012, Berkshire Hathaway has made a whopping 20% annualized return for its investors. That’s more than twice the 9.4% return an investor would have made if she had invested in an S&P 500 index during the same period.
However, the only reason Berkshire has done so well is that it is being managed by a once-in-a-generation group of financial whizzes led by Warren Buffett. Once he retires, he is now 83 years old, the new CEO may or may not do as well. It’s a gamble. A gamble that his wife, who previously worked as a waitress in a cocktail bar and not as stock market investor, is not qualified to make.
What is Berkshire?
Berkshire is an international conglomerate of businesses that encompasses several sectors. The fact it has such diverse holdings is one of the reasons it has weathered so well the ups and downs of the last 50 years. Nevertheless, it is still only one company, and investing in a single company, even one as wildly successful as Berkshire, is a huge risk.
The take home lesson is that you should diversify your retirement investment. Investing in an S&P 500 index is like betting on the entire American economy. As long as the American economy grows as a whole, your investment is safe.
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For the record, a truly diverse portfolio should also include investments in a blend of international and domestic stocks, real estate holdings and cash market instruments. But Mr. Buffett has repeatedly expressed his optimism about the future of America’s economy, and he is willing to put his wife’s money where his mouth is.
Why Invest in an Index Fund Instead of a Managed Mutual Fund?
Ok, I get why Mr. Buffett recommends diversifying your savings, but how can an index fund outperform the diversified portfolios of mutual funds actively managed by expert stock market pickers?
The superior performance of index funds over the vast majority of managed mutual fund has been confirmed time and time again by countless studies. Warren Buffett’s favorite index, the Vanguard 500 Index (VFINX), has outperformed 80% of all actively managed large-company, U.S.-centered stock funds in the last three years.
Is it because mutual fund managers are morons or scammers? Not at all. It’s just that consistently picking the right stocks is extremely difficult. So difficult, several Noble prize winners say it’s so difficult you might as well pick stocks at random.
In his letter to Berkshire investors, Mr. Buffett elaborates on why he has no confidence in managed mutual funds:
Both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm.
Here, Mr. Buffett hits on the two key reasons why managed mutual funds fare badly when compared to plain vanilla index funds. There are more reasons but these two are enough to make the point.
First, managed funds charge higher fees, which makes index funds a better choice even when managed funds outperform them by a small margin. To illustrate, the average management fee for an actively managed mutual fund in 2013 was 1.44%. Compare that to the 0.17% management fee of VFINX. A typical managed fun has to outperform Vanguard’s VFINX by 1.27% just to match it.
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Second, because fund managers believe they can time the market they need to have cash on hand so they can buy stocks they feel are a good deal. Cash reserves can represent 3 to 7 percent of the funds holdings. That money is just sitting around without generating any interest. Index funds, on the other hand, only buy and sell stocks when there is a change in the companies that comprise the index fund, which means they don’t need cash reserves. It also means they trade less often, which saves money on trading commissions and costs.
Isn’t Mr. Buffett Doing The Exact Opposite of What He Recommends?
Although it is true that he doesn’t follow his own advice, he isn’t being hypocritical. He has never claimed investing in index funds is the smartest move for Warren Buffett, just for the rest of us.
He has been timing the market and picking stocks his entire life. but he has the experience, information and a level of investing skill most of us will never even come close to attaining. So, unless you, or your financial adviser, have the skill and access to private information that Warren Buffett has, stop wasting money on expensive fund managers and make a B-line to your closest low-cost index fund provider.
Invest like Warren Buffett, at least while he’s still around
Simply imitate every trade he makes. He is forced by law to disclose his investments in Berskhire’s quarterly report. Seriously, we all should do this.
What is surprising, considering Mr. Buffett consistent performance in picking stocks during the last five decades, is how few people are doing this. Unless you believe the Oracle of Omaha (one of Warren Buffett’s nicknames) can really see into the future, the only explanation for his success is he is a particularly insightful investor and has access to private information that is not publicly available.
If that is the case, why aren’t investors, who understand how hard it is to pick stocks, copying his stock purchases, which are publicly available? If enough people did this, any advantage he may have would be negated, but until then, they (or we) could be as successful investors as Mr. Buffett.
A group of researchers from the UCLA and Hong Kong University of Science and Technology actually performed a study on this phenomenon and concluded that overconfidence in their own stock-picking abilities and their independent private information is the only explanation why sophisticated fund managers aren’t shadowing Mr. Buffett’s portfolio.
Don’t be arrogant. Be smart and either invest like Mr. Buffett, or at the very least, like his wife does.
Andrew is the managing editor for SuperMoney and a certified personal finance counselor. He loves to geek out on financial data and translate it into actionable insights everyone can understand. His work is often cited by major publications and institutions, such as Forbes, U.S. News, Fox Business, SFGate, Realtor, Deloitte, and Business Insider.