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Warren Buffett has an easy way for most people to make money over the long run. And it doesn't involve picking winning stocks.
He believes that most people should "own a cross-section of businesses that in aggregate are bound to do well." The simple way to do this is to invest in an index fund. Here's how Buffett's favorite index fund could make you a millionaire.
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In his 2013 letter to Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B) shareholders, Buffett recommended that most investors should put their money in a low-cost S&P 500 index fund. He even noted that his will instructs that 90% of the cash inherited by his family be invested in such a fund.
An S&P 500 index fund certainly meets Buffett's advice about owning a broad cross-section of businesses. These funds invest in the 500 large-cap companies that make up the S&P 500. Those companies represent 11 different sectors and 24 industries.
But there are quite a few S&P 500 index funds available. Which is Buffett's favorite? He has provided two big hints.
First, Berkshire Hathaway's portfolio includes two S&P 500 exchange-traded funds (ETFs): the SPDR S&P 500 ETF Trust (SPY +0.00%) and the Vanguard 500 Index Fund ETF (VOO +0.00%). Second, Buffett mentioned in his 2013 letter to Berkshire shareholders that he "suggest[s] Vanguard."
Based on these two hints, there's a strong argument to be made that Buffett's favorite S&P 500 index fund is VOO. That's not surprising, considering it has a very low expense ratio of only 0.03%. By comparison, SPY's expense rate is 0.0945%.
But can investing in VOO really make you a millionaire? Based on history, the answer is a resounding "yes."
If we only looked at the last 10 years, the average total return of the S&P 500 was a little over 12.5%. Note that this percentage includes reinvesting dividends. However, that period featured an exceptionally long bull market. Over the last 50 years, the average annual total return of the S&P 500 was close to 10.7%.
The total return is only one component of the equation, though. How much you invest, how regularly you invest, and how much time you allow your investments to grow are also very important. The table below shows what it would take to make $1 million using the historical average total return of 10.7%.
| No. of Years | Amount Invested Per Year |
|---|---|
| 10 | $60,672 |
| 20 | $16,121 |
| 30 | $5,322 |
| 40 | $1,867 |
Calculations by author.
Of course, there's no guarantee that the S&P 500 will generate the same level of returns going forward as it has in the past. However, even if the returns decline somewhat, making $1 million by investing in VOO is a realistic goal for many individuals.
Buffett didn't make his fortune by socking away money in an S&P 500 index fund, though. He invested in individual stocks. For anyone seeking to follow this different path to becoming a millionaire, Buffett has also offered sage advice.
He and his longtime business partner Charlie Munger treat buying stocks in essentially the same way they do in buying entire businesses. They try to estimate the earnings potential for the company for at least five years into the future. Then, they determine if the stock price is reasonable compared to that projection. If not (or if they don't feel comfortable with estimating earnings), they move on.
The good news for most investors is that they don't have to do so much work. They can buy a low-cost S&P 500 index fund like VOO -- and simply wait. Or they can find someone with a great track record of success in investing to do the work for them in picking individual stocks that are likely to be winners over the long run.