Warren Buffett: How Most People Should Invest in 2023

Since 1965, Warren Buffett, the world's best investor, has been laser-focused on buying individual stocks and trying to beat the market to benefit the shareholders of Berkshire Hathaway. And he's done that very successfully, with an average annual return of 20% versus the S&P 500's rough 10%. But one thing that's interesting about Warren is that he doesn't actually recommend most people do what he does. He instead recommends that most people should subscribe to passive investing and simply dollar-cost average into a market-tracking index fund.

So, in this video, I want to explore Warren Buffett's reasoning and why passive investing is usually the most reliable strategy for most investors to achieve strong returns in the stock market.

Jack Bogle has probably done more for the American investor than any man in the country. Jack—there he is—Jack Bogle. He founded the Vanguard Group, we all know today, back in 1974. In 1975, he introduced the first index fund for individual investors called the Vanguard 500 Index Fund, which aimed to track the performance of the S&P 500 Index. This was a radical departure from the prevailing investment philosophy at the time, which emphasized actively managed funds that attempted to outperform market averages through stock picking and market timing.

However, Bogle's belief was that most actively managed funds actually underperformed the market due to the high management fees. And actually, index funds were a more cost-effective and efficient way for individual investors to access solid market returns. And what do you know, he was right. Even today, research shows that 89% of actively managed funds have underperformed the S&P 500 over the last 15 years after factoring in their fees.

Jack Bogle, many years ago, he wasn't the only one that was talking about an index fund, but it wouldn't have happened without him. The truth is, it was not in the interest of the investment industry to have the development of an index fund, because it brought down fees dramatically. And as we've talked about, index funds overall have delivered for shareholders a result that has been better than Wall Street professionals as a whole. And Jack, at a minimum, has left in the pockets of investors without hurting them overall in terms of performance at all. He's put tens and tens and tens of billions into their pockets, and those numbers are going to be hundreds and hundreds of billions over time.

The argument from Jack was to try and provide regular investors a product that represented wide diversification across the market with very low fees, so they could achieve a return very, very close to the actual market average. If we turn to Investopedia, that average annual return for the S&P 500 has been 11.88% since its inception back in 1957. But interestingly for Warren, his strategy of stock selection has earned him over 20% annual returns since 1965.

So, why does he believe that most people should instead dollar cost average into an index fund?

"What do you consider the most important quality for an investment manager? It's a temperamental quality, not an intellectual quality. You need a stable personality. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd, because this is not a business where you take polls. It's a business where you think some people should not own stocks at all because they just get too upset with price fluctuations. Some people are not actually emotionally or psychologically fit to own stocks. But I think there are more of them would be if you get educated on what you're really buying, which is part of a business."

Two clips, one old and one recent, but it shows that Warren really hasn't changed his thinking over the decades. You know, the most important quality you need to do what he does successfully is to have a rational temperament. And the way you really achieve this as an investor is by truly understanding the investments that you've made. But to get to that point, you need to invest a lot of time and effort into studying each and every business that you look at. And realistically, that's just not achievable for most people.

You know, most people go to work, they work 5 days a week, and then they relax on the weekends. They don't want to spend every spare minute, you know, combing through earnings call transcripts and financial statements. At the end of the day, individual stock selection is difficult. It's not impossible, but it takes time, it takes dedication, and importantly, it takes a rational temperament. Ultimately, that's not something the vast majority of investors can properly commit to and execute.

So, Buffett typically advises against the strategy of individual stock selection. But on the flip side, passive investing through dollar-cost averaging is a lot easier to commit to and to properly implement. The very nature of index funds is that you are saying, "I think America's business is going to do well, reasonably well over a long period of time, but I don't know enough to pick the winners, and I don't know enough to pick the winning times." There's nothing wrong with that.

"I don't know enough to pick the winning times. Occasionally, I think I know enough to pick a winner, but not very often. And I certainly can't pick winners by going down through the whole list and saying this is a winner and this isn't, and so on. So, the important thing to do if you have an overall feeling that business is a reasonable place to have your money over a long period of time is to invest over a long period of time and not make any bet implicitly by putting a big chunk in at a given time."

This is Buffett perfectly describing the passive investing strategy. It's recognizing you don't know enough to pick the winners, and you don't know enough to pick the winning times. So, what passive investors do is they look at market-tracking investments, and then to combat their inability to pick the winning times, they invest the same amount of money into the market at the same time intervals. This is called dollar-cost averaging.

So, for example, one passive investing strategy might be to invest $22,000 every 6 months into an investment that tracks, say, the S&P 500. Another might be investing $500 a quarter into the FTSE 100. Ultimately, each investor's approach will be slightly different, but for passive investors, they'll all have the same two characteristics in common: a market tracking investment and a consistent investment schedule that spreads out their investments. They are simply participating in the stock market and deliberately setting themselves up to be completely and utterly average.

"Yeah, I would say that in terms of the index fund, I would just take a very broad index. I would take the S&P 500 as long as I wasn't putting all my money in at one time. If I were going to put money into an index fund in relatively equal amounts over a 20 or 30-year period, I would pick a fund, and I know Vanguard has very low costs. I'm sure there are a whole bunch of others that do; I just haven't looked at the field. But I would be very careful about the costs involved, because all they're doing for you is buying that index. I think that the people who buy those index funds on average will get better results than the people that buy funds that have higher costs attached to them."

And boy, you were right, Warren! But I did want to quickly touch on one more key point that Warren made in that video. Yes, he noted market diversification and investing at regular time intervals, but he also noted that this needs to be applied over a 20 or 30-year time period. This is the only really challenging thing about passive investing: committing to the length of time required for the strategy to actually play out.

For example, it's worth remembering, say I have a lot of old-school friends that are now passive investors, and sometimes they'll come to me and say, "Yep, I'm just collecting my 10% every year. Feels great." But technically, that's not exactly correct. While yes, historically this strategy has returned about 10% as an average annual return, you obviously don't just get 10% every year.

You know, last year you got -20%, the year before you got 27%, the year before that you got 16%. If you started this strategy in 2008, after 1 year, your expected 10% return was actually 38%. So, for this strategy to have the best shot at giving you a really stable return, you do need to commit to a long enough time period for your dollar-cost averaging to genuinely even you out to the long-term average annual return of the market.

But without doubt, passive investors that have genuinely been able to commit to a long-term time horizon have done very, very well over time.

"The best single thing you could have done on March 11th, 1942 when I bought my first stock was just buy an index fund, never look at a headline, never think about stocks anymore, just like it would do if you bought a farm. You just buy the farm, let the tenant farmer run it for you."

And I pointed out that if you'd put $10,000 in an index fund that reinvested dividends—and I paused for a moment to let the audience try and guess how much it would amount to—it would come to $51 million now. And the only thing you had to really believe in then is that America would win the war and that America would progress as it has ever since 1776—and that American business, if America moved forward, American business would move forward.

You didn't have to worry about what stock to buy; you didn't have to worry what day to get in and out. You didn't know the Federal Reserve would exist, whatever it might be. And, uh, America works. And honestly, that's going to be the biggest pro for the passive investment strategy. It's a strategy that, as we've talked about, has worked reliably for investors historically.

As we said before, the S&P 500's returned 11.88% annually since 1957. But in order to achieve this return, the investor didn't actually have to use their brain or give up their time. No financial statements needed to be read; you didn't have to watch CNBC; you didn't have to run any discounted cash flow analyses; you didn't have to, you know, sacrifice a weekend to study or listen to earnings calls. As Warren said, all you had to believe was that the American economy would move forward over time and American business would keep moving forward with it.

And in fact, for passive investors, it's genuinely better the less they pay attention.

So overall, that is the reason why the world's best active investor actually recommends passive investing. Now, I do just want to balance this video by saying that there are always risks involved with any sort of stock market investing, and this video is definitely not any sort of recommendation for you guys to go out and buy anything.

For example, there's always market risk when you're widely diversified. There's also concern from smart investors, like Michael Burry, for example, that index investing is removing price discovery from stocks, which means their respective market caps are no longer being set by underlying business performance, which means there's like a bit of a bubble forming. And another consideration to make as well is that remember, these index funds are programmed to just buy the biggest companies in a particular market.

But if you hold the largest 500 stocks in America, for example, chances are there will be some companies in there that probably don't align with your own values and beliefs. So there's still definitely a lot to consider before you go and call yourself a passive investor.

But anyway, guys, hopefully that gives you some insight into passive investing and why Warren Buffett recommends it for most investors. I hope you guys enjoyed the video. Please leave a like if you did enjoy it or if you found it useful. Subscribe if you want to stick around and see more videos similar to this.

But guys, apart from that, thank you very much for watching. We'll see you guys in the next video!