Does Warren Buffett Really Think Index Funds Are Best for You?

Last week, a fellow Fool passed along an article to me titled "10 Investing Facts You Probably Don't Know -- but Should." The author of the article, Daniel Solin, is a senior vice president at Index Funds Advisors (which seems like a bit of an oxymoron to me), and has written a series of books that focus on investing in low-cost index funds. So it's of little surprise that many of his "investing facts" pointed investors toward -- you guessed it -- index funds.

Now don't get me wrong, I don't have anything against index funds, but I think some of Solin's investment "facts" misfire and one in particular stood out to me. Solin writes:

Warren Buffett advises investors to invest in index funds: Over the years, Buffett has repeatedly recommended that investors stick to low-cost index mutual funds. He even prefers them to ETFs, as he explained in an interview on CNBC in May, 2007.

Interestingly, as proof the article links out to a MarketWatch article that says -- right at the beginning -- that:

Warren Buffett reiterated his view that for most small investors who don't have time to research individual companies, cheap index funds are the best way to invest in the stock market. [emphasis mine]

The basic idea behind the "wisdom" of index funds comes from the efficient markets theory, which says that markets are efficiently priced so you're wasting your time by trying to pick individual stocks and outperform the market. Buffett has actually thumbed his nose at this theory on many occasions, including his 1988 letter to Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) shareholders:

Naturally, the disservice done to students and gullible investment professionals who have swallowed EMT has been an extraordinary service to us and other followers of Graham. In any sort of a contest -- financial, mental, or physical -- it's an enormous advantage to have opponents who have been taught that it's useless to even try. From a selfish point of view, Grahamites should probably endow chairs to ensure the perpetual teaching of EMT.

Fun with semantics
If Solin chose his words a little more carefully, he actually could have been correct. Just about all people -- you, me, Derek Jeter, your cousin's mailman -- have a need to invest so that they can do things like send kids to college or retire. But even though all of these people are investing their money, I wouldn't call them all investors.

So what separates a true investor from everybody else? For one thing, a true investor feels the same way about the efficient market theory as Warren Buffett. That is, they see that while it may sound good to academics, it doesn't hold in the real world and the more the theory is accepted, the easier it makes it for true investors to find cheap stocks that EMT-followers aren't bothering to look for.

Maybe more importantly, investors are willing to pour time into research in order to track down bargain-priced stocks. Agreeing that mispricings exist is a start, but no real investor expects that undervalued stocks are simply going to fall into their laps without doing any research.

Now if we circle back to the original claim that Warren Buffett advises that investors stick to index funds, I think we can agree that it's simply not true. For the average person who doesn't have the time or interest to research individual stocks, Buffett likely would point them toward index funds. However, for investors who are willing to dive into Securities and Exchange Commission filings, industry research, and valuations, there's still good reason to track down the best deals in the market rather than simply buying the whole market.

Taking the efficient out of markets
There are many ways to go about tracking down undervalued stocks. The daily business news can provide some good ideas, you can drill down on a specific industry sector that you think has promise, Buffett has even claimed that he used to go through a list of all publicly traded stocks from A to Z looking for interesting investments.

Personally, I like to use screens. This allows you to pull up a list of stocks that meet certain criteria -- valuation multiples, company performance metrics, insider ownership, etc. Of course these lists are only a starting place for investors as more research is always needed since the numbers don't always tell the whole story.

Here are a few of the stocks that one of my favorite screens -- which looks for dividends, low price-to-earnings multiples, and high returns on capital -- spits out.

Company

Dividend Yield

Return on Capital

Forward Price-to-Earnings Ratio

Philip Morris International (NYSE: PM  )

4.4%

30.7%

13.9

H&R Block (NYSE: HRB  )

4.6%

24.7%

8.5

Pitney Bowes (NYSE: PBI  )

6.4%

10.9%

10.2

Garmin (Nasdaq: GRMN  )

4.7%

17.2%

12.1

Intel (Nasdaq: INTC  )

3.3%

20.9%

11.5

Source: Capital IQ, a Standard & Poor's company.

The statistical criteria that I set out in the screen drastically reduce the stock universe from thousands to (in this case) 83. But the real work starts with digging into the 83 to figure out which are actually worthwhile investments.

For instance, investors need to get comfortable with the future of cigarettes and litigation risks if they want to dive in and invest in Philip Morris International. With H&R Block, they have to decide whether the blockheaded decision to get into mortgage lending (since discontinued) was a one-time screw-up or if the tax-prep expert will continue to get in its own way.

Garmin was once the high-flying king of personal navigation, but investors now need to figure out whether a shifting competitive landscape and the rise of phone-embedded GPS will hobble the company. Pitney Bowes is grappling with a similarly shifting industry as it tries to fit its mail services into an increasingly electronic world. And, finally, Intel has been firing on all cylinders as demand for its chips spiked post-recession -- but have the recent good times simply been the peak of a cyclical swing?

So, are you a real investor?
Let's face it, everyone would like to have other investors eat their dust as they trounce the market with amazing stock picks. But the real investors actually relish digging into businesses to figure out whether the market has overlooked a bargain. Those true-blue investors can do well over the long term by continuing to look for individual stocks.

A non-investor ... well, they would rather watch a Dharma and Greg rerun, reorganize their closet, or go to the dentist. These folks are best advised sticking with the advice from Daniel Solin -- and Warren Buffett and Jack Bogle -- and picking up some low-cost index funds.

Real investors only: My fellow Fools have put together a free report detailing five stocks that The Motley Fool owns and they think you should own, too.

Berkshire Hathaway and Intel are Motley Fool Inside Value recommendations. Berkshire Hathaway is a Motley Fool Stock Advisor choice. Philip Morris International is a Motley Fool Global Gains recommendation. The Fool owns shares of and has bought calls on Intel. Motley Fool Options has recommended buying calls on Intel. The Fool owns shares of Berkshire Hathaway and Philip Morris International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Matt Koppenheffer owns shares of Intel, Berkshire Hathaway, and Philip Morris International, but does not own shares of any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy assures you no Wookiees were harmed in the making of this article.


Read/Post Comments (25) | Recommend This Article (36)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 08, 2010, at 2:24 PM, mrwizard555 wrote:

    i suggest that everybody really read some articles on efficient market theory/hypothesis. they will come to realize that EMT does not state that the market price for any asset is the true fair value for the asset. it really boils down to an average of all participants' estimate of current FV.

    Buffett tries to find assets that are currently undervalued. at the same moment that he does that, other participants feel that the same assets are overvalued, and an exchange can take place.

    way too many factors go into deciding valuations to say the EMT is wrong.

    for those who want to learn more about EMT and its variations, wikipedia has a good article to start you off.

  • Report this Comment On December 08, 2010, at 4:36 PM, lazytype wrote:

    It looks inefficient only if one has a knowledge.

    For someone with even bigger knowledge it looks even more inefficient.

    It's like a smarter, more educated person has greater insight into the world.

    It's all difficult, not easy as some Buffet quotations.

  • Report this Comment On December 08, 2010, at 5:03 PM, Melaschasm wrote:

    Thank you mrwizard555.

    I have been seeing way to many people incorrectly stating EMT. The way I like to describe the theory is fairly simple.

    EMT = A free market tends to more efficiently determine prices than a central planning committee.

  • Report this Comment On December 08, 2010, at 6:30 PM, bobthome wrote:

    To quote your article, "it (EMT) may sound good to academics, it doesn't hold in the real world and the more the theory is accepted, the easier it makes it for true investors to find cheap stocks that EMT-followers aren't bothering to look for."

    Someone should have replaced the managers of Hidden Gems with "true investors". I subscribed to Hidden Gems for years, and often times lagged the S&P by quite a margin. I didn't take all the advice, but the HG portfolio as a whole was lagging quite severely at the time I stopped subscribing.

  • Report this Comment On December 08, 2010, at 8:12 PM, JustMee01 wrote:

    "it really boils down to an average of all participants' estimate of current FV."

    And in that context, just exactly what does it contribute?

    It's telling us that the current price of a security reflects the average opinion of everyone trading it...

    Shazam!

    Thanks. That's very enlightening. Why do we need a fancy "Efficient Market Hypothesis" monaker for something that's intuitively obviously to the entire planet?

    The real question is not what EMT is. It's what it means. Is that consensus, minute-by-minute updated opinion of value MEANINGFUL?

    For my money, it means diddly-squat. I don't care what the system is: a consensus is illusory. If you average the opinions of tens of thousands of individuals with hundreds of different objectives and perspectives, their average opinion is meaningLESS, not meaningFUL.

  • Report this Comment On December 08, 2010, at 8:19 PM, TMFKopp wrote:

    Since mrwizard likes the Wikipedia version of the EMT definition I'll go ahead and repost the very first line of that entry:

    "In finance, the efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient". That is, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information publicly available at the time the investment is made."

    Now we can bicker about the details, but the bottom line is that if you follow EMT you're not going to bother doing anything more than investing in the whole market because, as the entry above says "one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis."

    However, if you think EMT is bunk, then you are also going to believe that there is the possibility of taking advantage of mis-pricings and other inefficiencies.

    Matt

  • Report this Comment On December 08, 2010, at 8:23 PM, TMFKopp wrote:

    @bobthome

    I'm sorry, you must have confused this with the sour grapes department. Based on the sliver of information that you've provided it's hard to say much about your experience, but over time Gems has been one of the most successful Fool newsletters. Because they're all small-cap picks, they tend to be more volatile than larger-cap stocks, but long term investing is about, well, the long term, not the shorter-term wiggles.

    Matt

  • Report this Comment On December 08, 2010, at 9:12 PM, enermart wrote:

    The last I read, Buffet stated that investing in index funds was an excuse for ignorance. A sure fire way for average returns.

  • Report this Comment On December 08, 2010, at 10:53 PM, JBivins wrote:

    I believe what buffet is saying is that the average Joe doesn’t haven’t the time or knowledge base to perform the due diligence that is required to take advantage of the weak form efficiencies of the market. Most investors in America should probably take the path of the defensive investor and not seek to earn spectacular returns, but protect against loss. Also, most investors should seek to protect against the high cost. Any one who has listened to Bogel "preach" probably knows the damage that trading and fund cost can do to your portfolio in the long run. Typically index funds have the lowest cost and diversify your entire portfolio across the entire market, thus reducing risk. I believe index funds are smart and I check my ego at the door and invest my entire 401k in them. I have a separate pile of money that I use for my amateurish attempts to find undervalued securities that could have long-term prospects.

  • Report this Comment On December 09, 2010, at 3:13 AM, ffrank1 wrote:

    Thanks JBivins for a thoughtful and accurate post. I now wish I had taken the approach you outlined: bulk of retirement funds in indexed funds with "play" money in a separate account.

    I think D Solin's views have been distorted -

    perhaps a matter of semantics, but I feel that the definition of "investor" is at the core of the debate.

  • Report this Comment On December 09, 2010, at 11:37 AM, henryking54 wrote:

    <<over time Gems has been one of the most successful Fool newsletters.>>

    Matt Koppenheffer,

    Stop lying. Hidden Gems is severely underperforming the S&P 500. Just look at the relative performance of Hidden Gems located on the front page of Fool.com:

    Hidden Gems:18.60%

    S&P 500: 79.40%

  • Report this Comment On December 09, 2010, at 1:44 PM, TMFKopp wrote:

    @henryking

    As you are a connoisseur of bashing The Fool, I know that you know those numbers aren't really representative of the stock picks that Hidden Gems has made.

    For the sake of other readers though, the performance presented on the front page is the data from the Gems real money portfolio, which was just started in early 2009. Since it's a real money portfolio, the money is being invested over time and the cash in the account has provided drag on the overall results as the S&P has charged ahead.

    If we look at just the currently-active picks that have been made in the real money portfolio, they are outperforming by just shy of 10%. If you adjust for the portfolio weightings of the picks, the outperformance is much higher.

    I didn't include stocks that have been sold out of the portfolio, but as a group, they delivered outperformance of 24%.

    If we look back to the "classic scorecard" which runs from 2003 to early 2009, it has outperformed the market by 35%.

    Sure, there have been some serious clunkers picked at Hidden Gems over the years, but the newsletter's overall performance has been quite good.

    Matt

  • Report this Comment On December 09, 2010, at 2:59 PM, henryking54 wrote:

    <<Since it's a real money portfolio, the money is being invested over time and the cash in the account has provided drag on the overall results as the S&P has charged ahead.>>

    The decision to invest the money over time rather than be fully invested right away in early 2009 -- a time when the market was cheaper than it's been in 40 years -- was a conscious decision and a very bad decision.

    Hidden Gems' advisors are fully responsible for their disastrous decision to have a cash drag in the portfolio and the reported underperformance is completely justified.

  • Report this Comment On December 09, 2010, at 3:03 PM, henryking54 wrote:

    <<the newsletter's overall performance has been quite good.>>

    According to Hulbert's Financial Digest, which includes the entire performance of Hidden Gems from inception to the present, the newsletter's picks are significantly lagging the S&P 500.

    Again, I advise you to stop lying to readers.

    Henry

  • Report this Comment On December 09, 2010, at 4:34 PM, TMFKopp wrote:

    @henryking

    Alas, I don't have Hulbert's numbers so I can't comment on that.

    All the best-

    Matt

  • Report this Comment On December 09, 2010, at 9:08 PM, bobthome wrote:

    Matt TMFKopp

    That was my first post ever on Motly Fool, and I'm thinking this second one will be my last. I thought folks would understand that I was just venting a bit, since I paid Motly Fool a substantial fee (Hidden Gems) for sub S&P results. I didn't really expect a response, so I was a bit surprised at your caustic comment ( "I'm sorry, you must have confused this with the sour grapes department. ".) Then I saw you were on the Motly Fool payroll. Makes more sense now.

  • Report this Comment On December 10, 2010, at 12:30 AM, TMFKopp wrote:

    @bobthome

    I'm sorry that you feel put off enough to swear off commenting on articles -- frankly, I think it can often add a lot to article to see some of the discussions that arise in the comments section.

    However, I think it's a bit of a shame that you decided that your first post ever would be one randomly bashing Motley Fool services. As I said, the discussions in the comments section can be really good, but generally only when they are thoughtful and stay on topic. This thread has now devolved (partially my own fault for my response to your original comment) into a back-and-forth over Hidden Gems (which wasn't mentioned anywhere in the article above) and it's not really helpful to anyone.

    I hope you'll rethink your position and join in on one of the many great discussions on The Fool site in the future.

    Matt

  • Report this Comment On December 10, 2010, at 12:09 PM, martystevens wrote:

    In regards to Matt's comments on using screens. I use them as well. I particularly like the free one at http://stock2own.com/StockAnalyzer.aspx. Its not the be all to end all but I find it cuts a lot of time in the search process.

    The site is inspired by the book Rule #1, but it all essentially leads back to the methods used by the oracle Warren Buffet himself.

  • Report this Comment On December 11, 2010, at 4:49 AM, TerrySteven wrote:

    Investing in the index makes a lot of sense. Over the last 50 years the s&p 500 has averaged an 11% annual return rate. This blows away 95% of all "investors" including the goons on wall street.

    Good Buffett links

    http://www.clickylinks.com/warren-buffett-links

    My favorite Buffet Quote

    "It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that."

  • Report this Comment On December 11, 2010, at 3:01 PM, aleax wrote:

    "The average opinion of every investor/trader" is not meaningless -- it can be a very useful *contrarian* indicator.

    Market sentiment on aaii.com, for example (the American Association of Individual Investors), is high right now, with 30% more bulls than bears (just passed that key 30% threshold...) -- and in the past, whenever the 30% threshold was passed, the market was then usually down over the next 6 months.

    After all, when "most everybody" is bullish, then of course most everybody will tend to be fully invested -- so where are new buyers going to come from, to bring in more money and keep the market rising? Whether the key threshold is 30% or some other level needs to be determined empirically, but it's logically clear that at SOME level "too many bulls, too few bears" MUST be a contrarian indicator...!

  • Report this Comment On December 13, 2010, at 6:33 AM, Pr0metheus wrote:

    I wonder what EMT has to say about the flash crash. Surely Accenture wasn't efficiently priced at $0.01 a share.

  • Report this Comment On December 15, 2010, at 2:42 AM, cimacircle wrote:

    Buffett wrote in his 1996 letter to shareholders:

    Let me add a few thoughts about your own investments. Most investors, both institutional and individual, will find that the best way

    to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.

    http://www.berkshirehathaway.com/1996ar/1996.html

  • Report this Comment On December 15, 2010, at 7:07 PM, TMFKopp wrote:

    Hey all, not surprisingly, Dan Solin doesn't agree with what I had to say. Here's his response on Huffington Post today:

    http://www.huffingtonpost.com/dan-solin/foolish-advice-from-...

    Matt

  • Report this Comment On October 05, 2011, at 9:15 AM, beastwork wrote:

    So you are debunking Warren Buffet's advice because you disagree on his use of the word “investor”? Seems a little sophomoric if you ask me. I mean that seems to be the crux of your entire argument here.

    If I buy stock in a company I am by definition an investor, whether I have a clue about the market or not. I think smart people get the point Warren and others are making and it is simple. Unless you are a “professional/knowledgeable/schooled” investor you are better off doing X,Y, and Z. I find it alarming that you have somehow missed that point or have simply chosen to ignore it so that you can write this article.

  • Report this Comment On May 29, 2012, at 11:35 PM, FatDividends wrote:

    Index funds are for lazy people that don't know what they are doing FACT.

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