This article was published on June 30, 2016, and was last updated on November 10, 2016.
Warren Buffett is arguably the best stock picker of all time, so it's no surprise that during turbulent times, many people ask themselves, "What would Warren Buffett do?" Fortunately, Buffett has discussed what he feels is the best way for most people to invest -- and it's not what you might think.
The best investment for most people to buy
During Berkshire Hathaway's (NYSE: BRK-A) (NYSE: BRK-B) annual meeting in late April 2016, Warren Buffett had some harsh words to say about hedge funds and investment consultants, saying they are often detrimental for anyone who follows their advice.
Instead, Buffett argued (as he has many times before) that most investors' best bet is to put their money into a low-fee S&P 500 index fund that will simply match the market's performance over time. He mentioned his bet with hedge fund Protege Partners, where he said that over a decade, the Vanguard S&P 500 Index Fund would beat five funds-of-funds picked by Protege. From 2008 through the end of 2015, the S&P 500 has beaten the hedge fund's cumulative return by nearly 44 percentage points (65.7% to 21.9%).
Buffett's point is that passive investors can do better than "hyperactive" investments, whose managers and other professionals charge hefty fees. Over time, these fees can lower your potential returns by thousands of dollars.
He continued on with his comments for some time, but the general point is that a passive S&P 500 investor is going to do just as well as American industry does, which, throughout history, has done pretty well. Over the long run, and over multi-decade time periods along the way, the S&P 500 has averaged total returns of nearly 10% per year. And as Buffett predicted in his 2016 letter to shareholders, American business should continue to do just fine over the long run.
It's important to point out that Buffett recommends this approach for most investors -- specifically, those who would otherwise employ professionals to invest their money for them. He was not targeting investors who have the time, desire, and knowledge required to research their own stock investments, much like Buffett has done over the years. People who buy and hold high-quality stocks for the long haul are not exactly "passive," but they do have the potential to beat the market -- a fact of which Buffett is living proof.
Pros and cons of buying an S&P 500 index fund
I've already mentioned some of the pros of index fund investing. The first is cost savings -- especially when it comes to S&P 500 index funds. In fact, the Vanguard S&P 500 ETF (NYSEMKT: VOO) comes with an expense ratio of just 0.05%. This means on a $10,000 investment, you'll pay just $5.00 per year in fees. Compare this to actively managed mutual funds, which can charge 1% or more, or to the often-astronomical fees hedge fund managers and investment consultants charge.
Another perk is that index investing is as low-maintenance of an investment strategy as you can find that has such strong long-term potential. Simply buy shares of your chosen fund, and let the market do the rest.
Index fund investing also takes emotion out of the equation. According to a study by Dalbar, the average investor's annualized returns were just 2.6% during the 10-year period from 2004-2013, approximately one-third of the S&P 500's annual return during that time period. This is mainly because emotion tells investors to do the exact opposite of what they should -- panic and sell when the market is falling, and buy when everyone else is at high prices.
The possible downside is that while you won't lose to the market, you aren't going to beat it, either. As I mentioned earlier, Buffett as well as other value investors are living proof that with the right research and know-how, it's possible to create a portfolio of undervalued stocks that can beat the market's return over long time periods. So, if you have the time to thoroughly research and value stocks, index investing may not be in your best interest.
It's not for everyone
Buying an S&P 500 index fund puts your investments on auto-pilot, and while you won't get rich quickly with this approach, you won't go broke, either. Nor will you pay thousands of dollars in fees to Wall Street investment managers along the way.
However, if you're willing to put in the homework to research and create a well-diversified portfolio of high-quality stocks to hold for the long term, go for it. That's what I do, and that's what The Motley Fool suggests for those who have the time and desire. The point is simply this: Whichever investment strategy you use to achieve them, one of your main goals should be to keep as much of your profits in your pocket as possible, and not in the pockets of hedge fund managers or high-fee investment consultants.