Investing Made Easy?
A month ago, Tim Ferriss sent out a blog post about his visit to Warren Buffett’s annual shareholder meeting in Omaha. In his post, he discussed what happened when he asked Buffett a question. Here is what Tim asked:
“If you were 30 years old and had no dependents but a full-time job that precluded full-time investing, how would you invest your first million dollars, assuming that you can cover 18 months of expenses with other savings? Thank you in advance for being as specific as possible with asset classes and allocation percentage.”
Buffett let out a small laugh and began. “I’d put it all in a low-cost index fund that tracks the S+P 500 index and get back to work…”
From an investing standpoint, I thought both the question and answer were outstanding for any investor to consider. Since we all know Buffett does his financial homework, maybe there is a bit of wisdom in investing in index funds.
What are Index Funds?
Index funds are just a basket of stocks compiled together, like eggs into an egg carton. For instance, the S&P 500 is a basket of the 500 largest US publically traded stocks. They are mathematically compiled into a basket (an index) so when you buy an index, you are effectively buying 500 stocks at once in one index.
Unfortunately, individuals can’t buy indexes. But they can buy a proxy called an Exchange Traded Fund (or ETF for short), which basically mimics the exact same moves of a particular index. So if the index goes up $1, the ETF goes up $1.
And they are literally dozens of them depending on which index you want to mimic. The S+P 500 index can be mimicked by trading the ticker symbol “SPY.” The Dow Jones Industrial Average index can be mimicked by trading the ticker symbol “DIA.” The NASDAQ 100 index can be mimicked by trading the ticker symbol “QQQQ.” And etc….
Why Indexes and not Mutual Funds?
There quite a few reasons why Buffett shrewdly chose to say index funds rather than saying “buy mutual funds!”
1- 80% of all mutual funds fail to meet or beat the S+P 500 average. So you have an 80% chance of not matching the market. Those are not great odds.
2 – Annual mutual fund fees can range from 1.5% to 3% of your assets not including a load fee. Therefore, you not only have an 80% chance of not outperforming the market, you will also be wacked by fees every year thereafter whether your mutual fund performs well or not. In contrast, most ETFs have fees of less than 0.5%.
3 – Indexes (and ETFs) trade like stocks so you can get in and get out whenever you want, rather than wait for the end of the day (as with mutual funds), and there is often no redemption fee for doing so. Because they trade like stocks do, you can also use stops, trailing stops and other orders to help minimize risk, as such strategies are shown in my guide to investing.
4 – Diversification is a snap as an index (or in our case an ETF) is already diversified. There is no need to continue to further diversify unless you want to hold other assets like real estate or international funds.
5 – Performance: Time and time again, history has shown beating the S+P 500 versus a mutual fund, individual stocks or other assets is hard to accomplish. This is why experts use the S+P 500 as the benchmark to beat.
Well if Buffett said it, it must be true, right?
While Buffett is well beyond my wisdom and his ideas make financial sense, there are a few things that we should be concerned about before heeding his advice.
§ The growth of the stock market is predicated on the growth the economy. So even if you choose a well rounded ETF and if the economy doesn’t grow as it had in the past, your ETF won’t grow.
- Choosing the right ETF is critical and can make a substantial difference in returns. Just looking to buy the S+P index is not necessarily the best choice. Take a look at long term past performance, expected future performance, and your personal tolerance for risk when determining which ETF is best for you.
- Not all ETFs are created equal. While there will be a few ETFs mirroring the same index, some ETF fund families have come up with a way to increase the performance of the ETF by recalibrating the weights of certain stocks within the index. These “actively managed” ETFs may cost a little more in fees but make up for it in better performance.
Where do I start?
Education: Whether you purchase my guide or seek investment strategies somewhere else, putting your hard earned money into what Buffett said still requires greater understanding than just one sentence. A few hours of learning can make quite a difference in whether you retire or you retire well.
Taking care of your financial future is not something to take lightly or to quickly dismiss based on your lack of time. It is that precious time we can’t find enough of now that makes the ability to have more time impossible. Simply put, taking some time now to orchestrate a better financial future will yield more time later.
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