In investing an index is a way to measure the performance of a group of stocks, and the S&P 500 index (the 500 largest companies in the US by market capitalization) is one of the best known examples. Indexes are often constructed using formulas and rules with the aim of being broadly diversified. An index fund is simply a way that money can be invested so as to mimic the performance of the index.
Warren Buffett is famous for advocating index investing. In the 2013 Berkshire Hathaway annual report, Buffett stated that his estate plan includes a cash bequest to a trust for his wife’s benefit and instructions to the trustee to put 10% of the cash in short-term government bonds and 90% in a low cost S&P 500 index fund.
Buffett has also noted the high fees that come with stock pickers and hedge fund managers and the excess trading that befalls most investors. Buying and holding a low cost index fund avoids all of that. Buffett even made a 10-year bet that an S&P 500 index fund would beat a collection of hedge funds – and he won the bet handily.#
So Buffett says to invest using index funds. But what does Buffett do? From the 2013 Berkshire annual report:
“When Charlie [Munger, Berkshire Vice Chairman] and I buy stocks – which we think of as small portions of businesses – our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out, or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings – which is usually the case – we simply move on to other prospects.”1
At Berkshire, Buffett buys select stocks (e.g., Apple Computer) and businesses (e.g. GEICO insurance). In other words, he’s extremely selective about which businesses he owns.
So we seem to have a paradox – Buffett is saying one thing but doing another.
The resolution to this paradox also lies in the 2013 annual report:
“Most investors, of course, have not made the study of business prospects a priority in their lives. If wise, they will conclude that they do not know enough about specific businesses to predict their future earning power.”2
Buffett is saying that most people do not understand how to analyze a business and therefore should not pick stocks. And he’s right. He’s also saying that he can analyze businesses and therefore he should pick stocks. And he’s right.
That leaves us with two groups of investors: those who understand businesses and invest in what they know; and those that do not know how to study a business and therefore should invest in index funds.
The critical question is this: do you really understand what you own?
We work with entrepreneurs of various stripes who are business owner-operators. They know their businesses extremely well. They can handle the risk that come with having most of one’s net worth in a single business. They can tolerate the inevitable ups and downs of the business cycle. These individuals can and should focus their assets and energy on what they know well. They are part of our first group.
There is one more category to consider. It’s a group made of individuals who know how to study businesses but who (unlike our entrepreneur clients) are not owners-operators. They are simply owners. They are owners who evaluate businesses and then own them for a long time. In fact, Buffett wrote about such a group in 1984 when he penned the article “The Superinvestors of Graham-and-Doddsville” where he profiled nine independent investment managers, each of whom recorded market beating results over significant time periods.3
Which is to say that there are a small number of investment managers who can generate good results. But – you better know what you own. You better know what you are getting for your money. You better know what to expect. You better know when results are likely to be good and when they are not likely to be good. If you don’t know these things then you should not hire an investment manager and you should use low cost index funds.4
Do you really understand what you own? Which category do you fall into?
Those who are owner-operators and know how to analyze businesses
Those who have a deep understanding of what the investment manager is doing
Those who do not fit into category 1 or 2 and therefore should invest in index funds
Berkshire Hathaway, Inc. Annual Report 2013
How those index funds are constructed is a topic for another day – suffice to say that the most common format – weighting stocks by market capitalization – isn’t necessarily the best way to construct an index
# In Berkshire’s 2005 annual report, Buffett had argued that active investment management by professionals – in aggregate – would over time underperform the returns achieved by amateurs who simply invest in an unmanaged low-cost index fund. He later wagered $500,000 that a Vanguard index fund would beat five fund-of-funds (a fund-of-funds is an investing vehicle that selects individual hedge funds) over the 10-year period from 2008-2017. One asset allocator agreed to the bet, also wagering $500,000. In aggregate, the five fund-of-funds invested in over 100 different hedge funds. Buffett won the bet – much to the joy of Girls Inc. of Omaha.