Warren Buffett, Part 2

Does anything seem odd to you about this quote:

"Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees."

Warren Buffet, Letter to Shareholders, Berkshire Hathaway Annual Report, 1997

What I find a little surprising about this quote is that Warren Buffett has probably never bought an index fund in his life. He is known as the savviest investor of the past 50 years, and he didn’t get that reputation by investing passively. Why would a successful active investor, like Mr. Buffett, recommend passive index funds to his company’s shareholders?

For starters, his approach cannot be duplicated by the average investor. His preferred method of investing in a company is to buy it outright. That’s why most of his former investments are now wholly owned subsidiaries of his holding company, Berkshire Hathaway. This includes businesses like GEICO Insurance, Helzberg Diamonds, and See’s Candies.

Occasionally, Mr. Buffett decides to invest in a company that is too big to swallow whole. But unlike you or me, when he buys some stock in Coca-Cola or American Express, he purchases 5-10% of the company. In a large publicly-traded firm, that’s enough to assume an influential position on the Board of Directors. It is widely rumored, for example, that Mr. Buffett was instrumental in the selection of the past two CEOs at Coke. The point is, when Warren Buffett invests in a company, he assumes substantial control over how the firm is operated. While this strategy has worked beautifully for Mr. Buffett, it is simply not an option for most of us.

So why does Warren Buffett trumpet the virtues of index funds in his letters to shareholders? Because it’s good advice for the individual investor. Index funds have lower expense ratios than actively managed funds. They are also more tax-efficient. But the most compelling reason to invest in index funds is that they provide higher returns over the long haul. Warren Buffett is well aware of this:

"By investing in an index fund, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb."

Warren Buffett, Letter to Shareholders, Berkshire Hathaway Annual Report, 1993

November 1, 2001

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