Warren Buffett: How the Average Person Can Become a Millionaire

So let's not kid ourselves. The reason why we spend so much time learning about investing is to make money. Whether you're saving up for a house or building wealth for retirement, we all have our own financial goals. In this video, Warren Buffett is going to talk about a simple strategy that you can use to grow your portfolio to millions of dollars without ever as much as ever researching a stock. Make sure to stick around to the end to see how Warren Buffett's advice can save you half a million dollars in your investment portfolio. Now, let's listen to what Warren has to say.

Good morning. My name is Ted Friedman. I'm from Cincinnati, Ohio. You said in a 1996 annual report that most investors will find that the best way to own common stocks is in an index fund that charges minimal fees. Two questions: First, there are a lot of different index funds that hold different baskets of stocks. What criteria would you use or recommend to select an appropriate index fund? Second, the price-to-earnings ratio of the S&P 500 is significantly higher than its historical average. What benchmark should an investor use in purchasing this index?

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 that. 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 because it's just a matter of math. If you have a very high percentage of funds being institutionally managed, and a great many institutions charge a lot of money for doing it, and others charge a little, they're going to get very similar gross results but different net results.

I recommend to all of you reading John Bogle's written a couple of books in the last five years, and I can't give you the titles, but they're very good books. Anyone investing in funds should read those books before investing, or if you've already invested, you still should read the books, and it's all you need to know really about fund investing. So I would pick a broad index, but I wouldn't toss a chunk in at any one time. I would do it over a period of time because the very nature of index funds is that you are saying, "I think America's business is going to do well over, or 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 businesses are 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. As to the right criteria as to when you should or shouldn't, I don't think there are any great criteria on that. I don't think price-to-earnings ratio, you know, determines things. I don't think price-to-book ratios, price-to-sales ratios, I don't think any—there's no single metric I can give you or that anyone else can give you, in my view, that will tell you this is a great time to buy stocks or not to buy stocks or anything of this sort.

It just isn't that easy. That's why you go to an index fund, and that's why you buy over a period of time. It isn't that easy. You can't get it by reading a magazine. You can't get it by, you know, watching television. You can't— you’d love to have something that said, you know, I mean that, you know, if P/E's are 12 or below or some number, you're buying; if they're 25 or above, sell. It doesn't work that way. It's a more complex business than that. It couldn't be that easy when you think about it.

So if you are buying an index fund, you are protecting yourself against the fact that you don't know the answers to those questions. But do you think you can do well over time without knowing the answers to those questions as long as you consciously recognize that fact? And you know, I would—if you're a young person and you intend to save a portion of your income over time, I just say just pick out a very broad index, and I would probably use the S&P 500 because I think if you start getting beyond that, you start thinking you should be in small caps this time and large caps that time, or this foreign side.

And as soon as you do that, you know you're in a game. You don't know; you're not equipped to play in all candor. That would be my recommendation. Charlie, I think his second worry is that common stocks could become so high-priced that if you bought index funds, you wouldn't expect to do very well.

I didn't think I'd live long enough to think that was likely to happen, but now I think that may happen. But probably what you're saying there is that they could get to a level, and they'd have to be at a sustained level like that for a long time. It could be there and stay there for a long time, in which case you might make three or four percent. But would there be anything way better than that around under those circumstances anyway? And pass the peanut brittle, please.

Well, in Japan, where something like this happened, the return from owning a nice index over the last 13 years or so is negative. Can something as horrible as that happen here? I mean, is it conceivable? I think the answer is yes. But the option in Japan, of course, is to have deposits in a bank or own Japanese bonds. It's somewhere between zero and one or one and a half percent.

So an index fund is a type of mutual fund or exchange-traded fund, commonly referred to as an ETF, with a portfolio constructed to match or track the components of an index, such as the Standard and Poor's 500 index, commonly referred to as the S&P 500. Index funds have grown rapidly in popularity in recent years. We owe a great deal of thanks for this financial innovation to the legendary Jack Bogle.

In 1976, Bogle introduced the Vanguard 500 Fund, which tracks the return of the S&P 500 and became the first index fund marketed to retail investors. Despite the easily apparent benefits of index funds, they weren't a hit right away. When the Vanguard 500 Fund was launched in its initial iteration, it raised only 11 million dollars. However, over time, investors began to see the huge benefits of index funds. Since its relatively humble beginnings, the Vanguard 500 Fund has become massive, with over 550 billion dollars in assets under management.

So now that we have a better understanding of what exactly index funds are and their history, let's talk about the three main benefits of index funds. The first benefit of index funds is their low cost. Unlike index funds, their counterpart, actively managed funds, typically charge much higher fees to invest.

Let's use an example to further demonstrate the point Warren Buffett made about the importance of avoiding fees. Let's say we have two funds: Fund A and Fund B. Fund A is an actively managed fund that charges a fee of one percent every year. Fund B is a passive index fund that charges 0.1 percent every year. Let's say you put 10,000 in each of these funds every year for 40 years, and over that time, both of these funds average an 8% annual return before fees.

How much do you think each of these funds would have at the end of the 40 years? At the end of 40 years, Fund A, the fund that charges the 1% fee, would have just under two million dollars in it. However, Fund B, the passive index fund that only charges 0.1% fee, would have an astonishing 2.5 million dollars at the end of the same time period—over half a million dollars more. This really shows the importance of avoiding high fees.

While both of these funds perform the same before fees, the lower fee fund left this investor with over half a million dollars more in his investment account. The second benefit is that index funds require virtually no time or research to manage the investments on your part. While a lot of people, myself included, really enjoy learning about investing and studying companies, most people simply do not.

That makes index funds a great option for these people. They can simply invest a set amount every paycheck into a diversified index fund and never have to worry about the stock market or what particular stock to pick. The third main reason that index funds are so popular is that they ensure an investor will receive investment performance in line with the market. A big risk of investing in actively managed funds is underperformance.

With these actively managed funds, people are choosing which stocks to invest in and when to buy and sell. As such, there is a chance the person making these decisions on your behalf is simply not a good investor. But by buying an index fund, you ensure that your investment returns will match the overall return of the stock market.

While many people view this point as a benefit of index funds, performing in line with the overall stock market is also the biggest potential drawback of index funds. Now, let's revisit our early example to see just how beneficial outperforming the market can be for an investor's net worth. So let's say instead of that 8% return we talked about earlier, an investor is really good at picking stocks and achieves a 12% annual return.

In this scenario, an investor would have a portfolio worth 7.67 million dollars—more than three times the amount the investor who just received a market return of 8% had at the end of the same time period. This example really shows why it can be very beneficial to pick your own stocks, assuming you're good at it.

I just want to take a minute and thank everyone for watching this video and, more importantly, putting up with my subpar voiceover and editing skills. We have grown this community to nearly 50,000 people, and it keeps getting bigger every day. I really hope you guys are enjoying learning about investing, and I can't tell you how much I appreciate the positive feedback.

So there we have it. Make sure to like this video and subscribe to the channel because it is my goal to make you a better investor. Talk to you soon.