Why Warren Buffett Says You Should Invest in Index Funds

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About nine years ago, Warren Buffett made a $500,000 bet. He wagered that a simple index fund would outperform an actively managed hedge fund run by expert investors. Which would you pick?

Before you decide, here is some additional information about the fund contenders:

• Index funds buy a mix of stocks in a proportion that represents the overall stock market or a particular market segment. Index funds are typically managed automatically by a computer algorithm, and management fees for this type of fund are usually very small — around 0.1 percent or sometimes even lower.
   
• Hedge funds put money into alternative investments that can go up if the stock market goes down. Of course, hedge funds also try to provide maximum returns and beat the stock market if possible. Hedge funds may invest in real estate, commodities, business ventures, and other opportunities that fund managers think will hedge against potential stock market losses and produce good returns. These funds are actively managed and have high management fees of around 2 percent or more.

Buffett picked a simple S&P 500 index fund for the wager. He bet against an investment manager who picked a set of five hedge fund portfolios. After letting these investments play out for nine years, Buffett announced the results of this wager in the chairman's letter in this year's annual report for the holding company he controls and runs, Berkshire Hathaway: The index fund outperformed the actively managed funds. (See also: The 5 Best Pieces of Financial Wisdom From Warren Buffett)

Buffet's experience mimics numerous studies that have shown that index funds consistently beat the results of actively managed funds. Why does a simple and essentially automatic investment strategy (the index fund) outperform sophisticated investment funds managed by active expert investors?

Low fees

Fund fees, also known as expense ratios, are much lower for index funds than for actively managed hedge funds or mutual funds. You can find index funds with fees under 0.1 percent, while actively managed hedge funds can have fees of 2 percent or more.

Although the wager Buffett made concerned hedge funds with high expense ratios, the same principle applies when comparing index funds to actively managed mutual funds, which can have fees as high as 1 percent. Higher fees mean that actively managed funds have to outperform the market significantly to offset them. Over the long run, actively managed funds may not consistently outperform the market by enough to make up for the higher fees.

Investment errors

Another reason actively managed funds can fall behind index funds is investment errors. In active funds, someone is making investment decisions and moving money around trying to get higher returns. Sometimes an investment manager can outperform the market and get higher returns, but this doesn't always work out. It only takes one mistake to wipe out a lot of investment gains. In an index fund, the only investment decision is to adjust the ratio of holdings to match the market segment of interest.

Index funds accurately reflect the performance of the market they are mirroring. The investment strategy is simple, and there is no opportunity for investment error. If you invest in an index fund, you will reliably receive similar returns to the market that your index fund represents.

How to buy an index fund for your portfolio

During my research for this article, I moved around $10,000 of my own investment funds from actively managed funds into index funds with much lower fees. I figured if index funds are good enough for Warren Buffett, they are good enough for me!

You can log in to your investment account website and view the expense ratios for your current investments and for other available funds. I found that my investment choices had expense ratios ranging from 0.02 percent to 0.83 percent — a difference of more than 40-fold. This is definitely a big enough difference to worry about.

A good first step is to check your own investment funds and find out how high the fees are. You may be happy with what you find, or you may decide you want to move to index funds with much lower fees.

Of course, when choosing your investment funds, you shouldn't look only at the expense ratio. You should balance your portfolio to include a strategic mix of large cap, medium cap, and small cap investments and an intentional balance of foreign and domestic stocks to meet your investment goals.

When I moved my investment money into index funds with very low fees, I picked funds that made sense to balance my portfolio. For example, I moved some funds from a mid-cap growth fund with a 0.3 percent expense ratio into a mid-cap index fund with a 0.07 percent expense ratio — over four times lower fees. In the long run, I think this is a bet that will pay off.

Even if you don't have $500,000 to wager, you might as well minimize what you are paying in fees by moving from actively managed funds to index funds. You'll keep more of your money working for you instead of having it go to work for someone else.