This article was updated on November 8, 2017, and was originally published on June 25, 2017.
Warren Buffett is widely considered to be one of the top stock pickers of all time, and his track record of investing Berkshire Hathaway's (BRK.A -0.64%) (BRK.B -0.45%) stock portfolio certainly justifies this reputation. Because of this, it may come as a surprise that Buffett's favorite investment for most Americans isn't an individual stock -- not even Berkshire itself. Rather, Buffett says that the best investments for most Americans are low-cost index funds.
How Warren Buffett feels about index fund investing
At Berkshire Hathaway's 2016 shareholder meeting, Buffett had some harsh words about investment professionals such as hedge fund managers, saying that it is often detrimental for people to follow their advice. Instead of going this route, Buffett said that most investors' best option is to put their money into a low-cost index fund.
Buffett's main reasoning in favor of index fund investing, and for S&P 500 index funds in particular, is that by definition, they will match the market's performance over time -- no more, no less. This may sound boring, but the reality is that the market's performance has been quite good over time, producing annualized returns of 9%-10% on average. And with rock-bottom management expenses, investors will be the beneficiary of virtually all of the gains -- not investment managers.
Essentially, Buffett feels that investing in a broad basket of stocks is a bet on American business, which he feels is sure to do well over time. "American business -- and consequently a basket of stocks -- is virtually certain to be worth far more in the years ahead," Buffett said in his 2016 letter to shareholders. In fact, Buffett has advised his own wife to invest her inheritance in index funds after his death.
On the other hand, some actively managed investment vehicles will beat the market in any given year, and some will underperform, but as a group, they will match the market's performance as well. However, because of the high fees many of these products charge, their investors are at an inherent disadvantage. In Buffett's 2005 letter to shareholders, there was a section titled "How to Minimize Investment Returns," in which he argued that active investment returns by professionals would underperform amateurs who simply invested in the broad stock market over long periods of time.
For example, the Vanguard S&P 500 ETF (VOO 0.24%) has an expense ratio of just 0.04%, meaning that just $4 out of every $10,000 goes toward fees. Many actively managed mutual funds charge 1% or more ($100 out of every $10,000), while hedge funds often have a "two and 20" fee structure -- a flat 2% of assets plus 20% of gains.
High-fee products were the investment industry standard for many years until companies like Vanguard popularized the concept of passive index fund investing. In fact, Buffett has said that Vanguard founder Jack Bogle has done more for American investors than anyone else.
Buffett has put his money where his mouth is -- and won
As I mentioned, in his 2005 letter to shareholders, Buffett made the case against active investing in general, claiming that paying "helpers" may result in American equity investors earning just 80% or so of what they would if they just left their money in the market for long periods of time.
Buffett then offered to wager $500,000 that no professional could select a portfolio of at least five hedge funds that would match the performance of the Vanguard S&P 500 Index Fund over a 10-year period. An investment manager named Ted Seides took Buffett up on his offer and chose a basket of five "funds of funds."
Well, through nine years, the results weren't even close. The five hedge funds, as a group, managed only a 2.2% annualized return, compared with a 7.1% average return for the S&P index fund. This means that a $10,000 investment in the hedge fund portfolio would have grown to $12,200, while a simple S&P index fund would have turned $10,000 into $18,540. Not even the best-performing of the five hedge funds beat Buffett's S&P 500 index fund selection. Buffett estimates that 60% of all of the funds-of-funds' gains went to management fees even though they dramatically underperformed the market.
So should you avoid stocks altogether and just buy index funds?
To be perfectly clear, I'm not saying that you shouldn't buy individual stocks, and neither is Buffett. In fact, if you have the time, knowledge, and desire to research and evaluate stocks, you should do so.
Buffett's point is that the average American doesn't have the time, knowledge, and desire to properly invest in individual stocks. After all, "many companies, of course, will fall behind, and some will fail," as Buffett puts it. Also, Buffett feels that most actively managed mutual funds and hedge funds do a better job of compensating their managers than beating the market for their investors -- especially over the long run.