Some Investment Advice From Warren Buffett: Invest In Low-Cost Index Funds. It's Advice Ignored By The 'Elites'

| About: Berkshire Hathaway (BRK.A)
This article is now exclusive for PRO subscribers.

In Warren Buffett's annual letter to the shareholders of Berkshire Hathaway (BRK.A, BRK.B), just released recently, he offers some advice on how to invest wisely using low-cost index funds (emphasis mine):

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 a statue is ever erected to honor the person who has done the most for American investors, the hands-down choice should be Jack Bogle. For decades, Jack has urged investors to invest in ultra-low-cost index funds. In his crusade, Bogle amassed only a tiny percentage of the wealth that has typically flowed to managers who have promised their investors large rewards while delivering them nothing - or, as in our bet, less than nothing - of added value.

In his early years, Jack was frequently mocked by the investment-management industry. Today, however, he has the satisfaction of knowing that he helped millions of investors realize far better returns on their savings than they otherwise would have earned. He is a hero to them and to me.

Over the years, I've often been asked for investment advice, and in the process of answering I've learned a good deal about human behavior. My regular recommendation has been a low-cost S&P 500 index fund. To their credit, my friends who possess only modest means have usually followed my suggestion.

I believe, however, that none of the mega-rich individuals, institutions or pension funds has followed that same advice when I've given it to them. Instead, these investors politely thank me for my thoughts and depart to listen to the siren song of a high-fee manager or, in the case of many institutions, to seek out another breed of hyper-helper called a consultant.

That professional, however, faces a problem. Can you imagine an investment consultant telling clients, year after year, to keep adding to an index fund replicating the S&P 500? That would be career suicide. Large fees flow to these hyper-helpers, however, if they recommend small managerial shifts every year or so. That advice is often delivered in esoteric gibberish that explains why fashionable investment "styles" or current economic trends make the shift appropriate.

The wealthy are accustomed to feeling that it is their lot in life to get the best food, schooling, entertainment, housing, plastic surgery, sports ticket, you name it. Their money, they feel, should buy them something superior compared to what the masses receive.

In many aspects of life, indeed, wealth does command top-grade products or services. For that reason, the financial "elites" - wealthy individuals, pension funds, college endowments and the like - have great trouble meekly signing up for a financial product or service that is available as well to people investing only a few thousand dollars. This reluctance of the rich normally prevails even though the product at issue is -on an expectancy basis - clearly the best choice. My calculation, admittedly very rough, is that the search by the elite for superior investment advice has caused it, in aggregate, to waste more than $100 billion over the past decade. Figure it out: Even a 1% fee on a few trillion dollars adds up. Of course, not every investor who put money in hedge funds ten years ago lagged S&P returns. But I believe my calculation of the aggregate shortfall is conservative.

The chart above shows that the performance of the average hedge fund has lagged the S&P 500 (NYSEARCA:SPY) index over the last decade. A $100 investment at the beginning of 2006 in the S&P 500 would have more than doubled to $231 today (through January 2017), compared to only $169 today if the $100 had been invested in the average hedge fund. In 9 of the 11 years displayed above, the S&P 500 had a higher return than the average fund, including each of the last 8 years. That trend continues this year so far through January - 1.9% return for the S&P 500 versus 1.4% for the average hedge fund.

Human behavior won't change. Wealthy individuals, pension funds, endowments and the like will continue to feel they deserve something "extra" in investment advice. Those advisors who cleverly play to this expectation will get very rich. This year the magic potion may be hedge funds, next year something else. The likely result from this parade of promises is predicted in an adage: "When a person with money meets a person with experience, the one with experience ends up with the money and the one with money leaves with experience."

Long ago, a brother-in-law of mine, Homer Rogers, was a commission agent working in the Omaha stockyards. I asked him how he induced a farmer or rancher to hire him to handle the sale of their hogs or cattle to the buyers from the big four packers (Swift, Cudahy, Wilson and Armour). After all, hogs were hogs and the buyers were experts who knew to the penny how much any animal was worth. How then, I asked Homer, could any sales agent get a better result than any other?

Homer gave me a pitying look and said: "Warren, it's not how you sell 'em, it's how you tell 'em." What worked in the stockyards continues to work in Wall Street.

I think Warren Buffett's insights about how human behavior affects the investing decisions of many wealthy investors is very insightful, and explains why thousands of them pay (waste?) collectively billions of dollars in fees for returns that are inferior to low-cost index funds. Could it maybe a matter of some of the wealthy elites falling prey to the human weaknesses of superiority, pride, smugness, vanity, and "bragging rights" on the golf course? After all, who among the wealthy elites would get any respect on the golf course for bragging about being a Boglehead who primarily invests in low-cost Vanguard index funds?