Why Does Warren Buffett Like Index Funds?

Warren Buffett is perhaps the world’s most successful and well-known investor.

His Berkshire Hathaway Inc. (NYSE:BRK.A) is a powerhouse investment firm valued at over $600 billion. The Oracle of Omaha has spent his life building Berkshire but the trustee of his estate was instructed to invest 10 percent of his estate in government bonds and the other 90 percent in a low-cost S&P 500 index fund.

So, why does Warren Buffett like index funds? 

The wealthy don’t typically flock toward such a vanilla investment – they prefer individual businesses, real estate, and expensive purchases like fine art. Often, they pick high-profile investments like a sports team. These risky investments have a high financial barrier to entry and aren’t accessible to the average person.

And while Buffett may have some of these investments too – such as farmland – he prefers index funds for his widow upon his death. 

Why does Buffett prefer these low-fee diversified funds while his wealthy peers eschew them?

Charlie Munger Vs Buffett Disagree Over Index Funds

Unlike Buffett, Charlie Munger – his long time partner – has a different philosophy. Charlie believes both his and Buffett’s heirs should hold onto their Berkshire Hathaway shares. He believes the firm has a bigger upside than the S&P 500 itself, even though it’s a component of that index.

In some ways, Berkshire isn’t much different than an index fund. The company owns over 60 businesses, and collectively they generate enormous sums of cash. That doesn’t even include the accretive acquisitions and investments on the horizon.

Berkshire Hathaway also focuses on dividend-paying investments that provide steady income streams. The company doesn’t pay a dividend itself, believing that it can use the cash more wisely than its shareholders. Dividend stocks like Apple (AAPL), Bank of America (BAC), and Coca Cola (KO) make up the bulk of the firm’s portfolio.

Buffett and Munger don’t always agree, and that’s not unusual. The blend between their investment styles ensures Berkshire minimizes long-term risks while turning in a consistently strong performance. If you’re going to invest in a single stock, Berkshire has historically been a solid buy.

Still, Buffett is a strong advocate for index funds.

Why Does Warren Buffett Advocate for Index Funds?

Buffett outlined a 90/10 investment plan in his 2013 annual letter to Berkshire shareholders. He recommended to invest 10 percent of cash into government bonds and 90 percent into an S&P 500 index fund. He also recommends you reinvest the dividends to take advantage of compound interest.

Index funds don’t charge hefty fees, which saves money compared to a hedge fund.

They also diversify your investment – you may believe in a sector or type of business but may not pick the correct one. Instead of putting all your money into one stock, you get a broad range of investments that protect you from losing your full investment.

Amazon (AMZN) and Google (GOOG), for example, grew out of the dotcom bubble, while thousands of car companies went defunct in the past century. Just because a market segment is growing doesn’t mean every company within it will. In fact, most will fail.

Buffett thinks index funds are the safest and most intelligent way to preserve and grow your wealth over a long period of time. And one reason boils down to CEO risk. He is likely concerned that one day a poor CEO at Berkshire could damage it whereas the chances of 500 poor CEOs all gravitating to the top job of S&P 500 companies is low – hence leadership risk is diversified.

But which index funds is he buying?

Is Warren Buffett Buying Index Funds?

Buffett is a long-term investor who seeks investments he can buy and hold. Throughout the pandemic, the firm made few buys and sat on nearly $150 billion in cash. In retrospect, he has claimed he just couldn’t move fast enough to deploy tens of billions of dollars when the Federal Reserve acted so fast.

The firm doesn’t invest in a lot of index funds though. It takes Buffett’s advice and invests in several S&P 500 indices though. That includes owning shares of the Vanguard S&P 500 ETF (NYSEMKT:VOO) and SPDR S&P 500 ETF (NYSEMFT:SPY). Combined, these two funds account for over $25 million worth of positions.

These are passive funds, as opposed to actively managed funds like the ARK funds. This takes the guesswork out of investing and ensures the fund closely follows the index it’s tracking. They also have low expense ratios below 0.10 percent, compared to nearly 1 percent for a mutual fund.

It also signals that the company is trying to do something with its large cache of liquidity to avoid losing purchasing power. Instead of currency inflation, it’s tying its financial success to the broader market. But how well can it do?

How High Could S&P 500 Go?

There’s no limit to how high the S&P 500 can go. It continued hitting new highs in the wake of the pandemic, even as the economy was destabilized. And it’s not a static list of companies – businesses are constantly added to and removed from this index.

In 2020, Tesla entered the S&P 500. While TSLA share price is stabilizing now, other companies are continuing to grow. This makes the S&P 500 a good measuring stick of where the market is at any given time.

And the market continues to grow. There’s no 20-year period in the stock market’s history in which money invested didn’t return a gain. The market’s growth can continue with no limits, and that’s why it’s such a great index.

Why Does Warren Buffett Like Index Funds: Conclusion

Warren Buffett’s Berkshire Hathaway is one of the most prominent and successful investment firms on the planet. It’s a component of the S&P 500 itself and even invests its money in S&P 500 funds. This makes the value of both reflexively connected for the foreseeable future.

And the company invests in a lot of profitable cash-cow businesses. Its broad portfolio makes it almost like an index fund itself. But Buffett left strict instructions for his heirs to pull their money out of Berkshire and invest in the S&P 500 upon his death. That’s going to happen sooner than later, so brace yourselves for impact.

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