Investing

Warren Buffett: How 'the average person' should invest in the stock market

Even when there's a stock sell-off, as there was in 2020, "the average person" should stick to this investing strategy, according to Warren Buffett.

Warren Buffett, Chairman and CEO of Berkshire Hathaway.
David A. Grogan | CNBC

For decades, Warren Buffett has provided investors with a sense of calm and reason, especially in times of extreme stock market volatility

So far, 2020 has been one of the most dramatic years ever for the stock market. Feeling blindsided by a sell-off isn't atypical: "The light can at any time go from green to red without pausing at yellow," Buffett famously said to Berkshire Hathaway shareholders three years ago.

When 2014 started, the last bull market was in the midst of a particularly strong run, having surged 16 of 19 months. Then, that January, the S&P 500 tumbled nearly 5.6% in less than two weeks. Shortly thereafter, Buffett revealed for the first time how he's planning to invest some of his money for the long term.

"I laid out what I thought the average person who's not an expert on stocks should do," he told CNBC's Becky Quick in an interview on "Squawk Box" in 2014

Here's the Oracle of Omaha's advice for long-term investors, which has remained consistent throughout his decades-long investing career.

'Keep your costs minimal'

About six years ago, Buffett detailed the strategy for his money after his death: He has instructed the trustee in charge of his estate to invest 90% of his money in a very low-fee stock index fund and the remaining 10% into short-term government bonds. 

Index funds are a type of investment that mimic the performance of a particular market benchmark, like the S&P 500 or the Dow Jones Industrial Average, both of which track the largest U.S. companies. 

For decades, Buffett has championed index funds. This year, the Oracle of Omaha reiterated his praise, saying: "In my view, for most people, the best thing to do is to own the S&P 500 index fund," at his company's first-ever virtual annual meeting on May 2. 

He believes his wife will get the best return with an index fund strategy, too. "She'll do fine with that. Anybody will do fine with that. It's low-cost, it's in a bunch of wonderful businesses, and it takes care of itself," he said in 2014 interview on CNBC. 

The fact that index funds are low-cost is one of the main reasons why Buffett finds them to be attractive. "Keeping costs to a minimum is enormously important in investing whether it's farms or buildings in New York. But particularly in stocks," he said during the same interview.

In my view, for most people, the best thing to do is to own the S&P 500 index fund.
Warren Buffett
Chairman and CEO of Berkshire Hathaway

'Ignore the chatter'

Index funds are also an attractive choice for average investors because they allow you to "ignore the chatter," Buffett wrote in 2014. 

Index funds are composed of a diversified selection of many stocks, which frees investors from trying to follow the news and accurately pick winners.

Day-to-day events shouldn't dictate your long-term investing strategy: "I watch everything. But I don't do it to make specific investment decisions," Buffett said on CNBC in 2014. "I wanna know what's going on. But I also don't think that I can make money by predicting what's gonna go on next week or next month. I do think I can make money by predicting what's gonna happen in 10 years."

VIDEO3:2003:20
How to plan for stock market downturns

Video by Stephen Parkhurst

Buffett used his own reaction to the 2008 financial crisis to make his case for parking money in an index fund.

Even though a severe recession was brewing, he never considered selling his investments because he was investing for the long term. "Why would I have sold my stocks that were small participations in wonderful businesses? True, any one of them might eventually disappoint, but as a group they were certain to do well," he wrote in his 2014 shareholder letter.

Sticking with his plan paid off: In March 2009 the S&P 500 entered one of its best and longest bull markets in history, which ended earlier this year. Over even longer periods of time, the S&P 500 has delivered average annual returns of about 10%. 

Let's use the index fund Buffett explicitly recommended as an example: Vanguard's S&P 500 Index Fund. If you invested $500 in this fund on the day Buffett suggested it, February 28, 2014, that would have nearly doubled in value to be worth $945 as of June 30, 2020, according to calculations by Grow.

That works out to a return of more than 89%. Rather than just calculating the change in price, which would be about 66% in that time period, we've calculated the total return. That assumes you reinvested the dividends — a portion of a company's or fund operator's profit — you earned each quarter, which is an easy way to grow the value of your portfolio.

'Invest in stocks as you would in a farm'

Buffett believes the average investor would be better off thinking, "I bought a business today," rather than a stock. To take the analogy even further, he recommended in his 2014 shareholder letter: "Invest in stocks as you would in a farm."

Changing your perspective on investing can help you focus on the long term. "Nobody buys a farm based on whether they think it's going to rain next year," Buffett said on CNBC's "Squawk Box" in 2018. "They buy it because they think it's a good investment over 10 or 20 years."

The problem is, because investors can "make decisions every second with stocks," as opposed to investing in a physical entity like stores or farms, "they think an investment in stocks is different than an investment in a business. But it isn't," he said in the same interview.

Buying into companies because you want to own them for years or decades to come is a strategy that doesn't change because of short-term events — even the current coronavirus pandemic and economic recession.

"Now coronavirus is front and center. Something else will be front and center six months from now and a year from now," Buffett told Becky Quick on CNBC's "Squawk Box" on February 24. "Real question is, where are these businesses gonna be five and 10 and 20 years from now? Some of them will do sensationally, some of them will disappear. And overall I think America will do very well. You know, it has since 1776."

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