In a 2017 interview, Warren Buffett called out the entire financial services industry. He essentially accused money managers of overcomplicating investing: "If they told everybody what a simple game it was, 90% of the income of the people that were speaking would disappear."
The simplicity Buffett is talking about is index fund investing. Index funds are low-cost, exchange-traded funds that track major indexes such as the S&P 500.
This approach has taken Wall Street by storm in recent years, with index funds controlling roughly 17% of U.S. publicly traded companies.
It's undeniable that the average investor is better off thanks to the invention of index investing, but should we abandon stock-picking altogether?
Image source: Getty Images.
Here are two reasons to embrace passive investing with open arms and one reason to approach it with caution.
Most active managers lag the market
If researching companies isn't your thing (keep reading to learn why you might reconsider this), then your investment options are essentially limited to actively managed funds or passive index funds. Actively managed funds aim to beat the market by picking individual stocks and bonds.
The problem with active funds is the vast majority lose to the market. And it only gets worse the longer you're invested:
|
Timeline |
Percentage of large-cap funds that underperform the S&P 500 |
|---|---|
|
1 year |
55% |
|
3 years |
86% |
|
5 years |
85% |
|
10 years |
90% |
|
15 years |
89% |
Data source: SPIVA. Table by author.
The data above is exactly why Warren Buffett believes the vast majority of investors should simply buy S&P 500 index funds.
In that 2017 interview, he said, "Consistently buy an S&P 500 low-cost index fund. I think it's the thing that makes the most sense practically all of the time."
When comparing the performance of actively managed funds against the market, it's hard to argue with Buffett's advice.
Active funds have higher costs
Not only do actively managed mutual funds underperform the market the majority of the time, but they also cost orders of magnitude more to own than index funds.
According to Morningstar, the average expense ratio for mutual funds in 2021 was 0.4 %. For comparison, the expense ratio for the Vanguard S&P 500 ETF (VOO 0.01%) is 0.03%.
If you invested $1,000 in a mutual fund with a 0.4% expense ratio, you'd pay $4 in fees. That might not sound like a lot, but when you consider that the same amount invested in VOO would only cost you $0.30, the cost difference becomes apparent.
In other words, you're spending more than 10 times the amount of money to invest in a fund that is most likely going to underperform the S&P 500.
If you have to decide between mutual funds and index funds, the choice isn't difficult.
The case for stock picking
Index funds are undeniably one of the greatest innovations in recent investing history, and I believe an allocation to a low-cost S&P 500 fund deserves a spot in every portfolio.
Image source: Getty Images.
But there's still something to be gained by investing directly in companies. Even if you don't beat the market right away, you're going to learn a tremendous amount about businesses and how they operate by researching individual stocks.
This knowledge and experience will compound over time and ultimately make you a much smarter and more successful investor. This is something you miss out on when simply buying the index.
Buffett is wise to preach about the benefits of index investing because many people will not be willing to spend the time to research businesses. But if you aim to be an above-average investor, you'll need to dip your toes into the pool of company buying.
And if you're thinking it's impossible for an individual investor to beat the market, considering that professionals rarely do so, read this article that explains why most fund managers lag their indexes.
