Warren Buffett Believes Investors Should Only Buy Index Funds; Is He Correct?
Passive Investing vs Active Stock Picking
How Significant are Index Funds to Investors?
I recently ran a poll on the investing app Public asking investors one question: “What Percent of Your Portfolio is in Index Funds (such as VTI, SPY, SCHD, etc)?” I gave 4 options: <25%, 25%-49%, 50%-75%, or >75%. Here are the results of this poll:
56% of respondents said <25%.
19% of respondents said 25%-49%.
12% of respondents said 50%-75%.
14% of respondents said >75%.
When referencing index funds in this piece, I am not referring to non-diversified funds, but broad market, widely-diversified index funds.
The results, while not surprising (which I will dig into why they are not), should be alarming. Warren Buffett said in a recent interview that “In my view, for most people, the best thing is to do is owning the S&P 500 index fund”. If the investing legend himself believes most people should invest in an index fund, then why don’t they? Let’s dig in.
Retail Investing and Trading
80% of professional Wall Street fund managers under-perform the major indices (Dow Jones, S&P 500, and Nasdaq) every year. 95% of day traders end up losing money. Study after study has pointed to the fact that it is very uncommon to outperform the S&P 500 in a period of time greater than 20 years. Recently, a wave of retail investors, investors outside of Wall Street, have been influenced by the drastic movement upward in stocks in the 2020/2021 bull market. This has caused a belief in many retail traders that they can outperform, and “get rich quick”. But this is far from the truth.
Investing platform Robinhood has come under criticism for turning “investing” into “gambling”, giving retail traders access to high-risk options contracts that can see their values plummet to zero in seconds. This “gambling” mentality extends into stock picking, as many of the stocks that are popular among retail traders are high risk, high speculation stocks that, in many cases, are fundamentally overvalued. Examples of this are GameStop, AMC Entertainment, Sundial Growers, Plug Power, and an array of penny stocks. Members of the subreddit r/WallStreetBets continuously call for a “massive short squeeze:, similar to what was seen with GameStop in early 2021, but these are yet to materialize.
The screenshot above shows a few more popular retail investor stocks, all of these are in the “Top 100 Most Popular” category on Robinhood. For reference, the S&P 500 is down 15% Year-To-Date.
Elon’s Point of View
In a series of tweets, Elon Musk voiced his concern and dislikes of passive investing, also known as investing in index funds. Here are a few quotes from his tweets:
“decisions are being made on behalf of actual shareholders that are contrary to their interests! Major problem with index/passive funds.”
“Jack Bogle (of Vanguard fame) said index/passive funds were too great a percentage of the market and he really knew what he was talking about! There should be a shift back towards active investment. Passive has gone too far.”
“Passive/index investment is simply an amplifier of active investment. If active investment signal degrades in quality, passive is proportionately impacted. Also, if there are very few actual active investors, their decisions can greatly increase company valuation volatility.”
I agree with the idea that decisions are being made on behalf of actual shareholders that are contrary to their interests. In the stocks that I invest in outside of index funds, I actively participate in the shareholder voting, and while many investors want nothing to do with this, I do, as I like to know and understands the decisions being made at the company are ones I can align myself with.
This 2nd quote is an opinion, is neither right or wrong.
There is a great amount of truth in the idea of few active investors can greatly effect company valuations if the majority of investors are passive, although I do not believe this is currently an issue in the market.
The major argument people who agree with Elon is that passive investing excludes you from the possibility of outsized returns. For example, passive index fund investors would have missed out on the 18,000%+ return on Tesla. While this is true, we must return to the stat that 80% of fund managers under-perform, and most traders lose money.
Elon makes the case against passive investing in index funds. In fact, THIS article from the Financial Times shares that passive funds have overtaken actively managed funds for the first time in history. This being said, only 16% of stocks are held passively in these index funds as ETFs. For Elon’s argument to gain significant traction, we would need to see this passive number greater than 50%, which is unlikely. If this were to occur, then we would face issues of the companies that control the index funds, such as Vanguard, State Street, and BlackRock, would have massive power in the voting for the companies held in the funds. This is worrisome, and is a valid concern if we keep seeing massive flows into passive funds.
Gambling vs Outperforming
Looking at the “gambling” view and Elon’s view, we see a common theme: the pursuit of out-performance. In the gambling view, traders have the desire to “get rich quick”, 2x, 4x, returns per year, with mega high risk. In Elon’s view, traders look to find stocks that they believe will outperform the market over a period of time, and buy and sell into stocks during times they believe certain sectors will perform better than others. Both of these strategies have greater risk associated with them than passive investing, and a lot more time and effort required.
The desire to outperform, I believe, is human nature. For some, the desire to out-perform comes out of wanting to retire earlier, and they are willing to take a moderate risk. Others, see it as gambling, and want the thrill of hitting big in the stock market. This mentality is what prompted Warren Buffett to make his “gambling parlor” comments, referring to the stock market as a gambling parlor at the 2022 Berkshire Hathaway shareholder meeting, in the wake of mass adoption of option contracts by retail investors. This mentality has proven to be dangerous, as this group of investors has lost massive amounts of money in the stock market in 2022.
The Case for Passive Investing
The chart above shows some of the most popular index funds, VTI, SPY, QQQ, DIA, and SCHD. These returns do not include the dividends these funds pay, with SCHD currently yielding 3% and the average yield around 1.5%, the true performance with dividends reinvested is higher than shown above.
Another theme to notice is the relative uptrend in most of these index funds. With QQQ generally being more volatile as it is mostly tech stocks, these funds have performed very well over the past 5 years, and very rarely were investors disappointed with their overall returns if they were in any of these funds. Even better for investors, they had to do next to nothing to achieve these returns, all they had to do was buy in regularly and sit on their hands watching. This is a highly attractive investment strategy, because the time to long-term benefit ratio is high, as the time is almost zero and the benefit and safety and security for investing over a lifetime.
Another benefit of broad market index funds are the returns during market downtrends. In downtrends like we are seeing now, where many stocks are down anywhere from 20% to 90%, index funds offer the protection of losses being minimized. This security offers additional incentive for investors who want to invest passively and have little to no concern about their portfolio.
Conclusion
In Conclusion, passive index fund investing has its pros and cons. Pros include stress-free investment, matching market returns, and lower risk investing. Cons are no outsized returns from single stocks, no ability to vote in shareholder votes, and leave the potential for large shareholders of individual stocks to have more power as an active investor. Determining your portfolio makeup is all about risk-assessment and risk-tolerance. If you are willing to put more time into your investing and keep up to date with company earnings and statements, then active investing in single stocks can be very profitable. On the other hand, throwing money at the S&P 500 and letting it go is a battle tested method to create wealth in the stock market. There is also no problem with mixing these two styles, splitting your stock portfolio between index funds and individual stocks. While Warren Buffett suggests most investors should buy an index that tracks the S&P 500, he picks stocks himself, and is an example of how to be successful at doing it. There are many paths to generational wealth, and index funds are one of them.