Buffett on How to Invest in Index Funds

Warren Buffett (Trades, Portfolio) has built a multi-billion-dollar fortune by picking stocks for his portfolio. However, despite his investing progress, he does not recommend that most investors follow his strategy and pick equities themselves. Instead, he recommends that investors put their money to work in index funds and let the market take care of the rest if they don't want to dedicate their professional lives to the business of investing.

The index approach

The reason why the Oracle of Omaha advocates this approach for most investors is the fact that investing is so difficult. Even though the billionaire has created a vast fortune for himself, he is the exception, not the rule. Survivorship bias is incredibly damaging in our ability to assess this situation.

We can see that the billionaire has made a lot of money investing in stocks and shares, but for every one Buffett, there must be at least 1,000 other investors who have lost everything by trying to follow the same approach. Investors should keep this in mind when analyzing potential investments and deciding on the strategy they want to follow to grow their wealth.

Dollar-cost averaging

The Oracle reiterated this point at the 2002 Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) annual meeting of investors. During the meeting, he was asked by a shareholder if he could offer any advice on how to pick index funds. He responded by saying that he would buy a “very broad index.” That would include the S&P 500, but only if “I wasn’t putting all my money in at one time.”

The billionaire went on to state that as well as trying to find a broad index, he would also review management fees. He would look for the most honest manager's lowest-cost fund offer.

However, he went on to reiterate that the most important factor is not to invest too much money at one point:

“So I would pick a broad index, but I wouldn’t toss a chunk in at any one time. I would do it over a period of time, because the very nature of index funds is that you are saying, I think America’s business is going to do well over a — reasonably well — over a long period of time, but I don’t know enough to pick the winners and I don’t know enough to pick the winning times.”

The aim of this strategy, he went on to explain, is to overcome the uncertainties of investing:

“I don’t think price-earnings ratios, you know, determine things. I don’t think price-book ratios, price-sales ratios — I don’t think any — there’s no single metric I can give you, or that anybody else can give you, in my view, that will tell you this is a great time to buy stocks or not to buy stocks or anything of the sort…So, if you are buying an index fund, you are protecting yourself against the fact that you don’t know the answers to those questions but that you think you can do well over time without knowing the answers to those questions, as long as you consciously recognize that fact.”

What Buffet is describing here is the process of dollar-cost averaging. This is a relatively established investment principle, but the evidence of it working better than any other strategy over the long term is mixed.

That’s not to say investors should ignore the Oracle‘s advice. As he explained, this approach has both psychological as well as financial benefits. It helps investors build exposure to the market, but it also reduces exposure to market volatility and periods of excess.

Having an index fund investment strategy is not an essential requirement, but these comments from Warren Buffett (Trades, Portfolio) show that a dollar-cost averaging strategy could be one way for casual investors to improve their outcomes from this straightforward index investing strategy.