Why Warren Buffett Recommends Index Funds (Passive Index Investing)

Last Updated on April 26, 2022 by Rational thinking

Warren Buffett recommends most investors to invest in passive index funds. In general, investors should not be active investors. Why?

Buffett recommends passive and low-cost index funds because he believes this is the most rational way to invest for most people. There are so many forms of mistake ordinary investors can make, but passive index investing limits those risks massively.

Obviously, Buffett has a very valid point. The average and median retail investor grossly underperform the indices, something that is well documented in research.

Why Warren Buffett recommends passive investing

My regular recommendation has been a low-cost S&P 500 index fund.

Berkshire shareholder letter of 2016

On page 685 of the Snowball Alice Schroeder has an excerpt where Warren Buffett explains why he recommends index funds to the ordinary investor:

Stocks are the things to own over time. Productivity will increase and stocks will increase with it. There are only a few things you can do wrong. One is to buy or sell at the wrong time. Paying high fees is the other way to get killed. The best way to avoid both of these is to buy a low-cost index fund, and buy it over time. Be greedy when others are fearful, and fearful when others are greedy, but don’t think you can outsmart the market….If a cross-section of American industry is going to do well over time, then why try to pick the little beauties and think you can do better? Very few people should be active investors….

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Why take the risk of finding multi-baggers when you can just sit back, relax and let your capital compound by being patient? Warren Buffett is a great investor, but he has had the patience to let his capital compound.

Buffett mentioned the mistake of buying and selling at the wrong time. Investing is difficult because you have to overcome these obstacles:

Investing involves the risk of behavioral mistakes

Most small investors buy and sell at the wrong times. Ample evidence has pointed out this year in and year out. If you make just one small timing mistake it can ruin your compounding capacity for many years. The risk of making a mistake far outweigh the gain of being right.

Stock picking is difficult

The returns in the stock market are mainly driven by a few outliers. How probable is it that you are able to pick those outliers? Most likely pretty slim.

Hendrik Bessembinder’s famous study from 2017 established that the majority of the listed stocks between 1926 and 2015 failed to beat short-term Treasuries during their listing.

Warren Buffett recommends Dollar-Cost Averaging

In the quote above Buffett recommends “buy over time”. What does he mean by that?

He is, of course, referring to dollar-cost averaging. It’s amazing how far you can get if you are disciplined and save every month for many years. Delayed gratification and compounding really work!

Warren Buffett recommends starting saving early

I packed my little snowball very early, and if I had packed it ten years later, it would have been very different than where it stands on the hill right now. So I recommend to students that if you start out a little ahead of the game – it doesn’t have to be a lot, but it’s so much better than starting out behind the game. And credit cards really get you behind the game.

The quote above, on page 702 in The Snowball, illustrates how important it is to start saving early. Buffett made 98% of his wealth after he turned 50, and 95% after he turned 65. Think about that!

Make investing simple:

Women are better investors than men. This is not because they are smarter, but because they don’t try to be smart. They are more likely to save regularly, timely, and forget about it.

Most investors should do the same, man or woman. Warren Buffett recommends passive index funds simply because you avoid making mistakes.