Warren Buffett recommends Exchange Traded Funds (ETFs) to most investors and for good reasons. As one of the greatest investors of all time, Buffett knows a thing or two about investing and being a stock market investor has made him a multi billionaire. Why not learn from the best?
So what is an Exchange Traded Fund (ETF)?
An Exchange Traded Fund is a security which can be bought on an exchange. There are numerous variations but the majority are index trackers (passive funds). Depending on which index the ETF is supposed to track, it will just buy the underlying investments of that specific index. This means that there is no fund manager actively trying to pick the best investments. It is basically a computer doing it and its performance will be very similar to the index it is tracking.
Let’s say it is tracking the S&P 500 (500 largest publicly traded companies in the US), then it will buy those 500 stocks at the same weight as the regular index has (if it is a physical ETF). The idea is that you get the index performance at a very low annual cost (0 – 0.5% normally) as there is no active fund manager to pay. It also gives you the diversification of the index, in our example these 500 stocks. For you as an investor, it might be appealing because you are immediately spreading your risks due to the ETF consisting of 500 american stocks and you don’t have to buy them individually yourself. The other key point is of course that the cost is very low and over time that has a massive impact on the value of your investments!
So in essence an ETF is a security which consist of a selection of securities (often stocks) with individual weights based on the index rules of the index the ETF is aiming to track. A computer does the work and hence the cost of owning this kind of security is normally very low compared to a normal mutual fund.
A little background to Mr Buffett
Warren Buffett has been investing in stocks for around 70 years so he should know a thing or two and it has made him one of the richest men in the world. Coming from a humble background, he started working when he was very young but he also started investing in the stock market. Over the decades he has bought many, many companies and most of them he still owns via his company Berkshire Hathaway (publicly listed company).
After spending decades finding what he calls “value stocks” and then working to unlock that hidden value, Warren Buffett has created an empire. He has always remained very humble and frugal and still lives in his old house in Omaha which he bought in 1958. By living the way he has (frugally) and spending decades investing in the stock market he has learned a lot about cycles, fear, greed and when is a good or bad time to buy stocks. He also has a very decent understanding of how the average investor as well as institutional investors behave and he often shares his views on these topics. When Warren Buffett gives advise on how to invest, one should pay close attention as there are few, if any, still active investors in the market with the same experience…
Why I think Warren Buffett recommends ETFs
The main reason is because of the low annual fee. This has a significant impact on returns over time and Buffet if anyone knows that. He has always been very frugal and always had a very long investment horizon. Many people were surprised when he said that he wanted his trust (when passed away) to invest 90% in ETFs linked to the S&P 500 and only 10% in cash. Personally I was not that surprised as he knows what it takes to consistently and over a long period of time beat a comparable index. It takes a lot and with the technology and information instantaneously available to almost everyone across the globe, it is getting harder and harder to outperform an index. With his extremely long experience he knows what is working and what is not and if he says that the average investor will do worse than the index and so will the majority of fund managers, why spend time and money on any of them?!
Knowing the right people and working across companies and borders to being able to scale and find synergies will work for some, like Warren Buffett. Unfortunately there are very few like him. This means that most actively managed funds are trying to beat a market (a benchmark index like the S&P 500) but according to statistics, they all fail most of the time! So why would anyone in their right mind pay 1 – 3% of their money in annual fees to a fund manager when they can buy the index through a cheap ETF?!
He still believes that over time one should always be invested in the market as it can be completely passive (you buy once or automate it to happen monthly) and should generate a decent return even if some years might be really bad. By being very long term (+15 years) and being ok with market fluctuations, the stock market should still be the place to be as that is where you get a piece of the action and where the upside is unlimited! Of course, you can still lose all your money and that’s why it’s so important to spread the risks, which is what buying an ETF linked to the S&P 500 will do. For you to lose all your money when you have invested in an ETF linked to the S&P500 (even if physical), all the companies in the index (all the 500 largest US companies) would have to go bust more or less at the same time!!
There will still be some people who over time will beat their comparable index but the question is if you or I will find that person… If not, we might be better off just making sure we spread our risks as well as paying as little in fees as possible since the high fees will eat your money away!
A rule of thumb on fees
Let’s say that me and two of my friends invest at the same time and our investment horizon is very long (towards our pension), say 30 years. One of us pays 1% in fees, another 2% and the third one 3% per year. We all invest in the stock market and we manage to get the same return per year BEFORE fees.
The scary thing is that one of us will have ALMOST twice as much as the other! The only difference was the level of fees which didn’t sound too high, did it?
Well, the rule of thumb is that if you invest for 30 years, manage to get 8% yearly return (historical average) and you pay 1% in fees every year, roughly 20% of your money will go to fees. If you pay 2% in fees, 40% of your capital will go to fees and if you pay 3%, 60% will disappear in fees!!
This slide is from one of my training sessions on Wealth and as you can see, a small thing like knowing what you pay and what you get, can literally save you hundreds of thousands of dollars!
Buffett knows this game inside out and if you have the right (very long) time horizon and don’t want to spend very much time on investing in the stock market, ETFs could be the right way for you. The last thing you want to do is sitting on the side lines merely as a consumer, that will never make you rich. Being an owner on the other hand can.
Historical performance is not a guarantee nor an indication of the future and before making any investments, you should always consult your financial fiduciary so that any and all investments you make are in line with your investment and risk profile.
As Warren Buffett points out – just make sure to own a piece of the market!
Actions to take:
- Check out our Wealth Section and indulge
- The Language of Money – a language for life
- Check out our Savings Section to make sure you keep as much as possible!
- If you want to become financially free – check out our video sessions
- Are you giving away HALF your PENSION(in fees)?
- Passive income investing – What, Why and How?
- The “easy” way of becoming a dollar millionaire
- Low costs – the effortless way to creating wealth!
- The Bucket System – Automating your finances
- How To Always Have Enough Money