Warren Buffett Is Wrong

by: Russ Thornton

In 2008, the Oracle of Omaha, Warren Buffett, took part in a bet.

For years, Buffett proclaimed that low cost index funds will beat more costly “active” investment managers over time.

As a quick refresher, an active investment manager believes they can beat the market through security selection and/or getting in and out of the market at the right times.

And in 2008, someone decided to challenge Buffett’s proclamation.

A gentleman named Ted Seides of New York-based asset manager Protege Partners.

The details of the wager were simple. Let’s see who performed better after 10 years.

In Buffett’s corner, an S&P 500 index fund.

In the other corner, Seides selected 5 “fund of funds” that collectively invested in 100 underlying hedge funds.

Each party staked $500,000 in this wager, and the loser will pay $1,000,000 to a charity of the winner’s choosing.

The bet runs through December 31st, 2017. You can see all the details here.

In Buffett’s latest letter to shareholders of Berkshire Hathaway, he rails against active fund managers for their excessive fees and generally lackluster results over time.

If you’re interested, you can see all of Buffett’s shareholder letters going back to 1977 here.

Up to this point, I take no issue with Mr. Buffett’s perspective.

In fact, I couldn’t agree more.

But where I disagree with Mr. Buffett is his investment prescription for you.

Buffett has many times recommended that most people would be well served by investing in a low cost S&P 500 index fund. He even makes that specific recommendation in his latest shareholder letter.

And while I think that many people would improve their odds of wealth-building success with an S&P 500 index fund, I also think it falls short of being the best solution for most of you.

As you may know, the S&P 500 index tracks the 500 largest publicly traded companies in the United States.

And while 500 companies is far better diversification than many of the portfolios I’ve seen over the years, it doesn’t represent “the market.”

Buffett regularly refers to the fact that active managers often fail to even keep up with market returns. And while many of these active managers are compared to the S&P 500 as their benchmark, the 500 largest publicly traded U.S. companies are only part of a much larger market.

And this is where I disagree with Mr. Buffett.

If you want to invest according to Mr. Buffett’s advice in a low cost index fund, I think the better choice is a low cost “total market” fund.

This would be a fund that, instead of tracking only the 500 largest U.S. based companies, tracks the ENTIRE U.S. stock market.

Instead of tracking the S&P 500, I suggest you should track the Wilshire 5000 which is widely regarded as the best proxy for the entire publicly traded U.S. stock market.

As the name Wilshire 5000 suggests, rather than just 500 large companies, it is designed to track close to 5,000 underlying stocks. Of all sizes. Across all industries.

To be clear, this isn’t an article about picking one investment over another. But it is about the concept of diversification.

And when it comes to diversification – if you ask me – the more the merrier.

Warren Buffett has been, and continues to be, a tremendously successful investor. So I think it makes sense to listen to what he has to say about investing.

I agree that low-cost index investing is best. It’s how I invest my personal money and what I recommend to all my clients.

But I think Buffett’s index investing advice could be improved by looking at a much broader (and more diversified) index than the S&P 500.

If you’d like to read more on Mr. Buffett’s latest letter to shareholders, his 10 year bet, and his thoughts on index investing, you should read the actual letter. In fact, all of his letters are worth reading and reviewing.

If you want to suck down Cherry Cokes and eat Dairy Queen as Buffett is often reported as doing (Coke and Dairy Queen are both in his portfolio), go right ahead.

And if you or your financial advisor are currently using active management in your portfolio, I wish you the best. Whether you beat the market or not, those fees – some of which are ridiculously high – will continue to add up.

When you’re ready for some low-cost index investing, I would skip Mr. Buffett’s advice and forgo the S&P 500 fund. Instead, I would go with a much broader, more diversified index like the Russell 3000 or Wilshire 5000.

In my opinion, that’s a truer way to “own the market” via index funds.