Warren Buffett thinks index funds are the best way for everyday investors to grow their money - here's how you can start

Tanza Loudenback

Dec 17, 2019, 21:59 IST

Warren Buffett thinks index funds are the best way for everyday investors to grow their money - here's how you can start

Lucas Jackson/Reuters

Warren Buffett recommends index funds for average investors.

Investing is the most powerful tool to build wealth, but it requires stomaching some risk.
Thankfully, you don't have to be a stock-picking genius to grow your money in the markets. In fact, legendary investor Warren Buffett suggests everyday investors stick to low-cost index funds.
You can start investing in index funds directly through a mutual fund provider, in your retirement account, or by opening a brokerage account at an online investor like Wealthfront, Betterment, or Ellevest.
Buffett is a huge fan of Vanguard, the creator of the index fund, for simple, low-cost, and high-performing options.
Read more personal finance coverage.

Warren Buffett is one of the most iconic and successful investors of our time. Luckily, he's an open book when it comes to his sharing his strategy and advice.

Buffett is a master of value investing wherein patience, discipline, and risk aversion are the essential ingredients for success. But he acknowledges that individual stock picking is not for everybody. In fact, most average, long-term investors would benefit from a much simpler strategy, he says: investing in low-cost index funds.

"My regular recommendation has been a low-cost S&P 500 index fund," Buffett wrote in his 2016 Berkshire Hathaway annual shareholder letter.

Index funds may sound intimidating, but they're just a basket of stocks that represent a broad market. In the case of an S&P 500 index fund, you're buying a small piece of the 500 largest publicly traded US companies. This results in automatic diversification, which minimizes your overall risk. Importantly, there's no market timing or individual stock picking involved - the fund simply tracks the performance of the stock index.

Buffett says index funds are 'the most sensible equity investment' for most people

Jack Bogle, the founder of Vanguard, debuted the first index mutual fund in 1976 to raucous criticism. But the late investor held firm to his belief that index funds would offer a way for investment firms to act efficiently and honestly, and still make money. Vanguard is now one of the world's largest investment funds, managing about $5.6 trillion in assets, and Buffett is a huge fan.

"A low-cost index fund is the most sensible equity investment for the great majority of investors," Buffett told Bogle in his book "The Little Book of Common Sense Investing." "By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals," Buffett said.

The most common ways to invest in index funds are directly through a fund owner, whether it be Vanguard, Fidelity, or Charles Schwab, or through your retirement account, such as a 401(k). You can also get access to index funds by opening a brokerage account at an online investing service like Wealthfront, Betterment, or Ellevest, though you may have to pay additional management fees.

Regardless of which method you choose, you don't have to dump a ton of money into an index fund to get started. Buffett actually recommends the opposite: Invest small amounts slowly over a long period of time. This is known as dollar-cost averaging and its a sound strategy for most long-term investors. Most importantly, Buffett says, never overpay in fees.

An index fund should always be low-cost

At his annual shareholder's meeting in 2002, Buffett said, "If I were going to put money into an index fund in relatively equal amounts over a 20 or 30-year period, I would pick a fund - and I know Vanguard has very low costs. I'm sure there are a whole bunch of others that do. I just haven't looked at the field."

"But I would be very careful about the costs involved," he continued, "because all they're doing for you is buying that index. I think that the people who buy those index funds, on average, will get better results than the people that buy funds that have higher costs attached to them, because it's just a matter of math."

Buffett is referring to a fund's expense ratio, or the fee you pay the brokerage to manage your investments, expressed as a percentage of your total account balance. It's taken out automatically, so it can be easy to miss, but it's clearly advertised on each fund. For example, if you invest in an index fund with a 0.50% expense ratio, the brokerage will take $5 for every $1,000 of your total account balance annually.

Index funds make investing financially accessible to the masses because they're designed to be passive, so they don't require much attention from fund managers. Three of today's biggest index fund providers - Vanguard, Fidelity, Schwab - typically charge less 0.10% on their most popular index funds, and some even charge nothing.

Disclosure: This post is brought to you by the Personal Finance Insider team. We occasionally highlight financial products and services that can help you make smarter decisions with your money. We do not give investment advice or encourage you to adopt a certain investment strategy. What you decide to do with your money is up to you. If you take action based on one of our recommendations, we get a small share of the revenue from our commerce partners. This does not influence whether we feature a financial product or service. We operate independently from our advertising sales team.