Warren Buffett,  the chairman and CEO of Berkshire Hathaway, is famous for his successful career picking stocks, but he says most investors are better off with a simpler approach that's still very effective: Invest in index funds.

Index funds are a type of investment that tracks the performance of a particular market benchmark, like the S&P 500, which mimics the performance of the 500 largest U.S. companies, or the Dow Jones Industrial Average. As part of his remarks offering some broader advice about investing at his company's first-ever virtual annual meeting on May 2, Buffett said, "In my view, for most people, the best thing to do is to own the S&P 500 index fund," which would track the S&P 500.

The S&P 500 has delivered average annual returns of almost 10% going back 90-plus years.

Investing in the market itself is a proven strategy for long-term success without being an expert. For years, the so-called Oracle of Omaha has championed index funds. He even instructed the trustee who will be in charge of his estate to invest 90% of Buffett's money into these assets for his widow.

Here's why index funds make sense for most investors.

Index funds don't require you to be an expert

Thanks in part to index funds, it's become cheaper and easier to invest in the stock market. And you may already be investing in index funds without realizing it. That's because these kinds of funds are the most common type of investment option to select from in many 401(k) plans or with automated investment services like robo-advisors.

By late 2019, the amount of money invested in funds that track the market surpassed the amount managed by people who pick stocks, and that's still the case, according to Morningstar Direct. As of March 31, data from the research firm shows that U.S. index funds have $3.79 trillion in assets, compared with $3.53 trillion for actively managed funds that have the goal of beating the market.

While professional investors make a living by trying to outperform the market, that strategy is hard to successfully execute over a long time period. Even Buffett cautions that it's difficult to do well. 

"With the exception of Berkshire, I would not want to put all my money in any one company," he said at this year's annual meeting. "You get surprises in this world, and there will be businesses that we think are very good that turn out not to be so good, and there will be other businesses that turn out better than we think." 

Individual stock prices can fluctuate. However, the broader index tends to go up over time — and with stock market index funds or exchange traded funds (ETFs), you don't have to pick the winning stocks to benefit from the total stock market's overall gains.

There are some inherent risks that come with investing in the stock market, but investing also offers a higher rate of return than the interest rates you'll earn on a savings account.

The 2010s in particular was an excellent decade to invest in index funds. Since bottoming out in March 2009, the S&P 500 surged more than surged more than 370% through the end of 2019.

And even with the turbulence in 2020 that delivered the first bear market in more than a decade, you'd still be ahead. In fact, if you'd invested $500 in an ETF that tracks this benchmark index — and reinvested your dividends, or the quarterly profit you're paid by the fund holder — the total return would be more than 420% and your investment would be worth more than $2,600 today.

Index funds don't charge hefty fees

Index funds pool money from a group of investors and then buy the individual stocks or other securities that make up a particular index. That model helps to reduce the associated costs that fund managers charge, compared to those funds where someone is actively strategizing which investments to include.

As Buffett put it during the annual meeting: "People will try and sell you other things, because there's more money in it for them if they do." That's why he believes the low-fee model of index funds is going to win with investors over time.

Video by Jason Armesto

Fees matter because they can cut into your overall return. Among equity mutual funds, which are made up of stocks, the average expense ratio for index funds was 0.08% in 2018, compared with 0.76% for actively managed funds, according to figures from the Investment Company Institute. That works out to $0.70 for every $1,000 invested versus $7.60.

By not paying a lot for someone to pick and choose your investments, you get to keep more money to reinvest in your portfolio.

What's more, you don't have to sacrifice on returns by investing in index funds. Only 11% of actively managed large-cap funds beat their benchmarks during the 2010s, according to a report from Bank of America Global Research.

Index funds are a simple way to diversify

With an index fund, the mix of stocks — what's known as its diversification — helps to minimize your portfolio's related risk. Because money is spread out across a variety of assets rather than just a handful of individual stocks, your portfolio is less likely to see sharp, short-term fluctuations. For example, an index like the S&P 500 typically moves up or down less than 1% on any given day.

You could buy all components of an index individually, but you'd spend a lot of money doing so. With an index fund, you can get all those stocks with the click of a button.

With the exception of Berkshire, I would not want to put all my money in any one company.
Warren Buffett
Chairman and CEO of Berkshire Hathaway

Diversification offers another important benefit: It increases the potential for your overall return. By freeing yourself from the arduous task of trying to accurately pick the winners, buying an index fund means you'll have a mix of some of the winners — and some of the losers.

While broad market index funds offer the most diversification benefits, there are index funds that have a narrower focus. For example, you can buy funds that track companies of various sizes (large-, mid- or small-caps), within specific industries like technology, health care, or real estate, and those that are listed on international stock exchanges.

How to invest in index funds

Because you don't have to be an expert investor to be successful, index funds can be a low-cost and easy way to beef up the diversification of your portfolio. That said, buying more funds doesn't necessarily offer any additional diversification benefits and you'll want to research index funds, just as you would any other asset, before investing.

Here are three questions to ask yourself when buying index funds:

  1. What are you tracking? Be sure you understand what index a particular fund is tracking — and what stocks (or other assets) are included in that index. Many indexes have similar names, even if they look nothing alike.
  2. What fees are you paying? While index funds are typically low cost, the associated administrative fees can still vary widely fund-to-fund. Pay attention to expense ratios and prioritize funds with lower fees.
  3. Do you have fund overlap? You don't need a lot of index funds to achieve diversification, and experts recommend that even a handful of funds can do the trick. That's why you'll want to pay attention to what indexes you're tracking (and components of those indexes) to ensure that you haven't loaded up on near-identical funds.

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