Index Funds: Warren Buffett’s Investing Advice for Everyday People

An index fund is a type of fund with an underlying portfolio built to track the components of a specific financial market, such as the Standard & Poor’s 500 Index (S&P 500)

These funds are equally distributed among the underlying companies that make up the index. This means that if you put one dollar into an index fund that one dollar is equally distributed among all companies in that index.

That might sound like it is in inefficient and you are somewhat correct but you are also highly diversified among all those different types of companies because an index doesn’t go specifically to one company.

So you could be investing in healthcare, financials, industrial, materials, consumers or consumer staples with that one dollar . OR you can invest in a Blockchain , Hospital , 5G or Renewable energy Fund if you think a specific type of sector will do well in the future .

This minimizes your risk in the case of the collapse of one company and sometimes a whole sector. Take for example the real estate crisis of 2008. That collapsed the whole real estate market but if you are investing in a broad market index fund, the loss would be A smaller percentage of your investment.

Index funds are Considered Ideal for retirement funds and any 401(K) . It is the Ultimate lazy way to invest and forget, Especially if you invest in an Index Fund that tracks the S&P 500 .

The Vanguard total market index fund the VTSAX has been trailing the S&P 500 and has shown exceptional gains in the past 20 years and more.

Even in the times where we had market corrections this index fund continue to perform exactly as the market would and corrected it self when the market corrected itself . Essentially you are investing in the US Economy as a whole and we have been Doing exceptionally well in the last 100 years .

So if you invested $10,000 back in 2009 without investing ever again that would’ve been equal to $35,876  today .

Performance of index funds

The S&P 500 top value have grown a massive amount in these past 10 years. From a low of 684 back in 2009 , up to a maximum 3108 as of writing this article , and is continuing its growth to all time highs. 

I’ll be using the index fund the VTSAX as an example of index funds throughout this article , The reason being it is a Total Market index that provides investors with exposure to the entire U.S. equity market, including small-, mid-, and large-cap growth and value stocks

If you bought into it starting at $20 back in 2009 , today you will have tripled your initial investment ( up 329% to date ) . Granted this number is slanted in favor of gains and not losses as the Financial crisis had just occurred and the only way was up .

Warren Buffet Easily one of the greatest investors of our time has praised index funds in one of his Shareholders Letters back in 2018 .

“Let’s put numbers to that claim: If my $114.75 had been invested in a no-fee S&P 500 index fund, and all dividends had been reinvested, my stake would have grown to be worth (pre-taxes) $606,811 on January 31, 2019 (the latest data available before the printing of this letter). That is a gain of 5,288 for 1. Meanwhile, a $1 million investment by a tax-free institution of that time – say, a pension fund or college endowment – would have grown to about $5.3 billion.”

He was speaking if he had invested in an index fund since 1942 . But nonetheless ,You could have potentially become a millionaire from the year 2011 until now , any people have done just that ! 

With the Internet this knowledge is no longer buried among specific circles , anyone can access this information if you just know where to look .

Index Funds During the worst years in recent History  

One Valid Concern is what to do in the event of a major recession .

With VTSAX , If you had been continuously investing from the year 2000 you would still be up %151 , this time period includes 5 downturns and corrections :

1. 2000-2003 where the market lost %30 
2. 2007 – 2009 Great Recession %42.11
3. 2011 Market Correction %12.30
4. 2015-2016 Another Market correction %9.8
5. 2018 A sharp correction of %15.5 

In Essence the Quote always to remember is

“ Time IN the market not TIMING the market “ .

Continuously investing during these years is actually very good , this allows you to lower the average price of shares and buy more in this discount market . Then when the economy inevitably revives in 1-2 years your investment will grow even more than before .

Sometimes the most major gains happen very suddenly and sporadically and if you had been continuously investing every month , there is a great chance you will have been awarded the full benefits. 

Right after these Downturns or “Bear Markets “ The economy usually starts moving again and Enters into “Bull Market “ . There have been two long running bull markets during this period, the market gained %101 , and %334 respectively . 

In short; Don’t worry about the ups and downs of the market , it is more important to stay disciplined and keep investing diligently to not miss out on the good days after the Bad ones .

Compound Interest 

This Article wouldn’t be complete without a discussion of This amazing Phenomena , As Einstein said,

“Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” 

Albert Einstein

This is very true as we have already discussed , Timing the market is very hard and will more likely than not , make you lose out on some of the best days the Markets make great gains . 

But I want to show how diligently investing works out and pays off .

Were going to Assume an 18 year old who continuously invests $100 a month through all of this will be worth today assuming he started in 1985 . 

As you can See in the chart above , Just by investing this simple amount . in 30 years the Net worth will be $121,000 on average . Now, Imagine if that investment amount was $1000 ?! By age 30 it would be $1.2 Million and in 65 years $15 Million ! 

I always enjoy plugging different numbers into the calculator and seeing the future results. If you wish to use the calculator too you can check it Here .

The True Passive investment  

Index Funds are probably the most passive investment you can ever get just by fact of existing and continuously putting all your savings into this one investment and reinvesting the distributions.

These types of funds are very different from dividend funds. Index funds don’t actually pay dividends every quarter or month but they do pay out a distribution yearly based on the amount of shares that you have owned 

That is why these types of investments are very optimal for retirement funds , as you don’t receive the value of your investment until you SELL your shares . The Growth of these funds is in fact how they appreciate in value.  

When one individual reaches retirement age , Shares are sold gradually each year to make sure the principle keeps growing while you live out the next 20-30 years of retirement . IF the principle is in fact substantial and you don’t withdraw as much as your investments appreciate then theoretically you can live off your investments forever ! 

Of course , There are other funds recommended to invest in to Balance out and diversify. I will quickly mention The three fund portfolios (A.K.A Lazy Investing Portfolio ) by Vanguard or Fidelity are excellent choices . These two funds have a balance of Domestic Stocks , Bonds , and international Stocks.

Index Fees Cost $0 To maintain

While I am a firm believer in active investing and I like to pick my own Stocks and build my own Dividend Portfolios . I understand the need to have a baseline Principle invested in index funds as studies have proven that a boring continuous investor even during market corrections will outperform an active manager all the time.  

Not to mention , Index funds have Less expense ratios than Actively managed Funds ! That might sound insignificant but even a 1% expense rate will add up over the course of a lifetime .

This was Also mentioned in Warren Buffet’s Same letter 

“Let me add one additional calculation that I believe will shock you: If that hypothetical institution had paid only 1% of assets annually to various “helpers,” such as investment managers and consultants, its gain would have been cut in half, to $2.65 billion. That’s what happens over 77 years when the 11.8% annual return actually achieved by the S&P 500 is recalculated at a 10.8% rate “

Most Mutual Funds are actively managed and hence they have slowly fallen out of favor as the preferred method for investing because of this reason alone. 

Index Fund Allocation by Age 

Up to 45 years old 

I mentioned you should have a healthy balance between three different types of investments . %60 Domestic Stocks , %20 Bonds, and %20 International Stocks . 

However , Young People have the Advantage of time on their Side and it is more recommended to go High Risk as you have time to make up the losses in case of a market recession . 

I Fall under this category and as such my entire portfolio is in Stocks . My protection in case of a market recession (Also called Hedge) are a healthy Emergency Fund with 6 months of expenses covered, My Job that i am still currently working, and Equity in my Home as a last resort .

My average return this year is 27% due in part to my heavy risk tolerance and allocation in stocks .

Between Age 45-65 

This is where it becomes gradually more important to Build up your %20 Bond allocation as you get closer to Retirement age .

The idea behind this is if a market correction happens you don’t want to risk your entire retirement going down and possibly not having enough time to get back to the original amount.

That is why having 20% allocation in bonds allows you to withdraw from the bonds while your stocks recover. The idea behind this is if a market correction happens you don’t want to risk your entire retirement going down and possibly not having enough time to get back to the original amount.

That is why having 20% allocation in bonds allows you to withdraw from the bonds while your stocks recover without decreasing your principal too much . 

Ages 65 and up 

in this age group bonds and stocks reverse percentiles so bonds will be 40% and stocks would be 20%.

Growth is not the main concern anymore . It’s more about preservation of the wealth you have gathered to this point and how well you manage it to last minute.

You don’t want to risk your retirement going down when you might absolutely need it the most especially with anticipated medical expenses.

Being able to draw from 40% portfolio of bonds will give you peace of mind over the next 20 years of retirement. And if Money is left over this will leave you Heirs a decent inheritance if you so choose to. 

Consult with a financial advisor or fiduciary for more information on how the best way to proceed. 

The Finale : Three Fund Portfolio 

Finally he gets to the point  !! I know it has been a long article but I really want to help you the reader be informed as much as possible . 

This is the result of meticulous research and learning and you could technically Skip to this part from the Get-go but there was always a lot of work to get to this result . 

As I mentioned earlier , A Three Fund Portfolio consists usually of a domestic stock “total market” index fund, an international stock “total market” index fund and a bond “total market” index fund.

This ultimately depends on the options available to you in your 401(K) by your company as that is the most common investment vehicle by far . But nonetheless , you can still use the concepts and mirror the same build of a three fund portfolio. 

The Two most common and recommended investment advisors are Vanguard and Fidelity , others are available too. 

The following three fund portfolios are constructed as Mutual funds

Vanguard funds

The funds that are best are:

• Vanguard Total Stock Market Index Fund (VTSAX)
• Vanguard Total International Stock Index Fund (VTIAX)
• Vanguard Total Bond Market Fund (VBTLX)

Fidelity Funds 

• Fidelity ZERO Total Market Index Fund (FZROX) or Fidelity Total Market Index Fund (FSKAX)
• Fidelity ZERO International Index Fund (FZILX) or Fidelity Total International Index Fund (FTIHX)
• Fidelity U. S. Bond Index Fund (FXNAX)

You can Also construct a three fund portfolio using Exchange traded Funds (ETF’s) 

• Vanguard Total Stock ETF (VTI)
• Vanguard Total International Stock ETF (VXUS)
• Vanguard Total Bond Market ETF (BND)

The Advantages :

• Diversification in Over 10,000 world-wide securities.
• Contains every style and cap-size.
• Very low cost , or No cost 
• Tax-efficient.
• No manager risk.
• No overlap.
• Low turnover.
• Easy to rebalance.
• Never under-performs the market (less worry).
• Mathematically certain to out-perform most investors.
• Simplicity

My Personal Philosophy in investing 

Some investors only look at the fundamentals and balance sheets when looking at investing and nothing else. Regardless of what a company does or how it does is irrelevant .   

That is Absolutely not my style . 

I am a very socially conscious investor and do not like to invest in industries that actively harm other Humans . Money is power in this day and age and where you deploy your money speaks volumes of a person’s character . I refuse to prop up unethical actions in the name of pure profit .

I am of the opinion that there literally thousands of companies to choose from , so my profits can be made elsewhere. Hence, I do not Invest in Tobacco , Arms and weapons , Gambling or predatory lending. 

These types of choices are my own Personal choices and i Encourage you -The reader – To be conscientious too but it ultimately is your own choice .  

To me this Principle is more important and worth losing a chance or two at these investments . In return , This is how as an investor I sleep well at night , even if I do not become the next Warren Buffet .

Now when it comes to Index funds, I like to Apply specific indices to judge if a index fund is socially responsible . Unfortunately none of which are with zero management fees , so I won’t list them here in the article but should you still be interested please contact me and I would happily let you know my choices.

Conclusion

Believe it or not , this only scratches the Surface of this topic and there is much more in depth analysis on the issue and even a greater debate on if index funds are creating a big bubble in the Economy. 

But If you need to take away one piece of knowledge from the entire website, and learn nothing else Here it is: Invest in a three fund portfolio directly from your paycheck and in 30 years when you retire you will have all you need. If you just do this I can almost guarantee you will be fine.

History has shown that this strategy has proven time and time again the Time in the market , consistency in investing monthly , and discipline to not withdraw anything until retirement is all that is needed. 

The reason I have gone in depth in my analysis was because there are certain concepts that will help you grow your skills as an investor and allow you to gain a strong foundation for individual investing too .

Learning the ups and downs of the markets inevitably will help you be better. But, as a baseline if you just continuously invest monthly into an index fund you can make sure your wealth will grow no matter what.

I structured our articles is to give a foundation of knowledge to be able to do the bare minimum. But if you always wish to branch out then there are specific techniques and different investments that you could try .

And I always recommend gaining as much knowledge as possible before trying something new !