With a net worth of more than $96.5 billion, as of July 2022, Warren Buffett is one of the most successful investors of all time. His investing style, which is based on discipline, value, and patience, has yielded results that have consistently outperformed the market for decades. While regular investors—that is, the rest of us—don’t have the money to invest the way Buffett does, we can follow one of his ongoing recommendations: Low-cost index funds are the smartest investment most people can make.
As Buffettwrote in a 2016 letter to shareholders, “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”
If you’re thinking about taking his advice, here’s what you need to know about investing in index funds.
Key Takeaways
- Index funds are mutual funds or ETFs whose portfolio mirrors that of a designated index, aiming to match its performance.
- Over the long term, index funds have generally outperformed other types of mutual funds.
- Other benefits of index funds include low fees, tax advantages (they generate less taxable income), and low risk (since they’re highly diversified).
What Is an Index Fund?
An index fund is a type of mutual fund or exchange-traded fund (ETF) that holds all (or a representative sample) of the securities in a specific index, with the goal of matching the performance of that benchmark as closely as possible. The S&P 500 is perhaps the most well-known index, but there are indexes—and index funds—for nearly every market and investment strategy you can think of. You can buy index funds through your brokerage account or directly from an index-fund provider, such as Fidelity.
When you buy an index fund, you get a diversified selection of securities in one easy, low-cost investment. Some index funds provide exposure to thousands of securities in a single fund, which helps lower your overall risk through broad diversification. By investing in several index funds tracking different indexes you can built a portfolio that matches your desired asset allocation. For example, you might put 60% of your money in stock index funds and 40% in bond index funds.
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Index Fund: Pros
Very low fees
Lower tax exposure
Passive management tends to outperform over time
Broad diversification
Index Fund: Cons
No downside protection
Doesn't take advantage of opportunities
Cannot trim under-performers
Lack of professional portfolio management
What Are the Benefits of Index Funds?
The most obvious advantage of index funds is that they have consistently beaten other types of funds in terms of total return.
One major reason is that they generally have much lower management fees than other funds because they are passively managed. Instead of having a manager actively trading, and a research team analyzing securities and making recommendations, the index fund’s portfolio just duplicates that of its designated index.
Index funds hold investments until the index itself changes (which doesn’t happen very often), so they also have lower transaction costs. Those lower costs can make a big difference in your returns, especially over the long haul.
“Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades,” wrote Buffett in his 2014 shareholder letter. “A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game.”
What's more, by trading in and out of securities less frequently than actively managed fund do, index funds generate less taxable income that must be passed along to their shareholders.
Index funds have still another tax advantage. Because they buy new lots of securities in the index whenever investors put money into the fund, they may have hundreds or thousands of lots to choose from when selling a particular security. That means they can sell the lots with the lowest capital gains and, therefore, the lowest tax bite.
If you're shopping for index funds, be sure to compare their expense ratios. While index funds are usually cheaper than actively managed funds, some are cheaper than others.
What Are the Drawbacks of Index Funds?
No investment is ideal, and that includes index funds. One drawback lies in their very nature: A portfolio that rises with its index falls with its index. If you have a fund that tracks the S&P 500, for example, you’ll enjoy the heights when the market is doing well, but you’ll be completely vulnerable when the market drops. In contrast, with an actively managed fund, the fund manager might sense a market correction coming and adjust or even liquidate the portfolio’s positions to buffer it.
It’s easy to fuss about actively managed funds’ fees. But sometimes the expertise of a good investment manager can not only protect a portfolio, but even outperform the market. However, few managers have been able to do that consistently, year after year.
Also, diversification is a double-edged sword. It smooths out volatility and lessens risk, sure; but, as is so often the case, reducing the downside also limits the upside. The broad-based basket of stocks in an index fund may be dragged down by some underperformers, compared to a more cherry-picked portfolio in another fund.
The Bottom Line
Index funds have several attractive pros but also some cons to consider. The funds are passive investments that track major indexes making them a low-cost investment option. These funds are nearly as automatic and hands-off as using a robo-advisorwhich is another option for those looking for low-cost investing. Understanding what an index fund is and how it compares to other investments is the best first step you can take.
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Bloomberg. "Billionaires Index."
Berkshire Hathaway Inc. "To the Shareholders of Berkshire Hathaway Inc.," Page 24.
Berkshire Hathaway Inc. "To The Shareholders of Berkshire Hathaway Inc.," Page 19.
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Warren Buffett is indeed one of the most successful investors of all time, with a net worth of over $96.5 billion as of July 2022. His investing style, which is based on discipline, value, and patience, has consistently outperformed the market for decades [[1]].
Buffett has often recommended low-cost index funds as a smart investment for most people. In a 2016 letter to shareholders, he wrote, "Both large and small investors should stick with low-cost index funds" [[1]]. Index funds are mutual funds or exchange-traded funds (ETFs) that aim to mirror the performance of a specific index [[2]]. They offer several benefits, including low fees, tax advantages, and low risk due to diversification [[2]].
An index fund holds all or a representative sample of the securities in a specific index, such as the S&P 500 [[2]]. By investing in index funds, individuals can gain exposure to a diversified selection of securities in a single, low-cost investment [[2]]. This broad diversification helps lower overall risk [[2]]. Investors can build a portfolio that matches their desired asset allocation by investing in different index funds tracking different indexes [[2]].
One of the main advantages of index funds is their low fees. They are passively managed, meaning they do not require active trading or extensive research teams, resulting in lower management fees compared to other types of funds [[3]]. Lower fees can significantly impact returns over the long term [[3]]. Buffett has highlighted that many institutional investors underperform index-fund investors due to high fees [[3]].
Index funds also have tax advantages. They generate less taxable income because they hold investments until the index itself changes, resulting in lower transaction costs [[3]]. Additionally, when selling a particular security, index funds can choose lots with the lowest capital gains, minimizing the tax burden [[3]].
However, index funds also have drawbacks. One drawback is that they do not provide downside protection. When the market drops, index funds that track the market index will also experience a decline [[4]]. In contrast, actively managed funds may have the flexibility to adjust or liquidate positions to buffer against market corrections [[4]].
Another drawback is that index funds do not take advantage of opportunities or trim underperforming securities. They aim to match the performance of the designated index, so they do not actively seek outperformers or adjust the portfolio based on market conditions [[4]]. Additionally, index funds lack professional portfolio management, which some investors may prefer for more personalized strategies [[4]].
In conclusion, Warren Buffett's recommendation to invest in low-cost index funds is based on their historical outperformance, low fees, tax advantages, and diversification benefits. However, it's important to consider the drawbacks, such as the lack of downside protection and the absence of active management. Ultimately, investors should evaluate their own risk tolerance and investment goals before deciding whether index funds are the right choice for them.
