Warren Buffett is arguably the best stock picker of all time, so it's no surprise that during turbulent times, many people ask themselves, "What would Warren Buffett do?" Fortunately, Buffett has discussed what he feels is the best way for most people to invest -- and it's not what you might think.
The best investment for most people to buy
During Berkshire Hathaway's (NYSE: BRK-A)(NYSE: BRK-B) annual meeting in late April, Warren Buffett had some harsh words to say about hedge funds and investment consultants, saying they are often detrimental for anyone who follows their advice.
Instead, Buffett argued (as he has many times before) that most investors' best bet is to put their money into a low-fee S&P 500 index fund that will simply match the market's performance over time. He mentioned his bet with hedge fund Protege Partners, where he said that over a decade, the Vanguard S&P 500 Index Fund would beat five funds-of-funds picked by Protege. Thus far, from 2008 through the end of 2015, the S&P 500 has beaten the hedge fund's cumulative return by nearly 44 percentage points (65.7% to 21.9%).
Buffett's point is that passive investors can do better than "hyperactive" investments, whose managers and other professionals charge hefty fees. Over time, these fees can lower your potential returns by thousands of dollars.
He continued on with his comments for some time, but the general point is that a passive S&P 500 investor is going to do just as well as American industry does, which, throughout history, has done pretty well. Over the long run, and over multi-decade time periods along the way, the S&P 500 has averaged total returns of nearly 10% per year.
It's important to point out that Buffett recommends this approach for most investors -- specifically, those who would otherwise employ professionals to invest their money for them. He was not targeting investors who have the time, desire, and knowledge required to research their own stock investments, much like Buffett has done over the years. People who buy and hold high-quality stocks for the long haul are not exactly "passive," but they do have the potential to beat the market -- a fact of which Buffett is living proof.
10 ways to invest to become a millionaire:
10 ways to invest to become a millionaire
10 ways to invest to become a millionaire
Include taxes in your tally.
Withdrawing money from retirement accounts is, of course, not a free ride, so $1 million gross is not $1 million net. “If the $1 million were in a traditional 401(k) or IRA, all withdrawals would be taxable,” says Christine Pavel, vice president of wealth management at GCG Financial in Deerfield, Illinois. “You also have to consider how much the investor will withdrawal from the portfolio, and for how long.” Assuming 3 percent inflation, looking forward 30 years and accounting for retirement account taxes, “An investor would be lucky to be able to withdraw $20,000 or less from the account for 30 years,” she says.
If you're in your 20s and start investing now, you’re in luck, says Joe Jennings, wealth director for PNC Wealth Management in Baltimore. “Due to the power of compounding, the first dollar saved is the most important, as it has the most growth potential over time,” he says. As an example, Jennings compares $10,000 saved at age 25 versus age 60. “The 25-year-old has 40 years of growth potential at the average retirement age of 65, whereas $10,000 saved at age 60 only has five years of growth potential,” he says.
Consider annuities as a building block.
Annuities, which people purchase to get an expected payout once they reach maturity – usually at or after retirement age – also have a rough reputation, particularly indexed annuities. But last year’s Qualified Longevity Annuity Contract regulation by the IRS set guidelines for investors to create their own pensions. “You can invest and put money in a retirement account, and with annuity guarantees that you will never outlive your money,” says Stan “The Annuity Man” Haithcock, an annuities expert and author of the book, "The Annuity Stanifesto," based in Ponte Vedra Beach, Florida.
It may seem sexier to get in on the latest initial public offering or that new stock your Uncle Mortimer promises will take off. But that’s no way to build a nest egg through the years, says Jim Merklinghaus, founder and president of JBM Financial in Rutherford, New Jersey. “My philosophy has been a conservative approach to retirement, investing consistently over a 30-year period of time. If your principal is 100 percent safe, you have already accounted for 12 years of a normal 30-year retirement. The plan that avoids the loss of principal far exceeds the joy of temporary returns,” he says.
Diversify between companies large and small.
Risk tolerance and portfolio mix are major factors in getting to $1 million, and they’ll differ depending on the investor. But if there’s one universal that applies, ”The portfolio should be diversified among large- and small-company stocks, domestically as well as in established foreign countries and emerging markets,” says Kenneth Moraif, senior advisor at Money Matters in Plano, Texas. “The appropriate allocation in each of these asset classes will be determined by the investor’s time horizon, their current assets, age and tax bracket.”
Use that 401(k) all the way.
Since retirement is the major savings goal with most nest eggs, make sure you maximize your retirement savings, says Andy Saeger, vice president and senior financial consultant at Charles Schwab in Naperville, Illinois. “Max out your 401(k) or other employer retirement plan, especially if you receive matching contributions. If you're age 50 or older, make catch-up contributions. If you can afford to save more, you may be eligible to open and contribute to an IRA, where your money can grow tax-deferred or tax-free until retirement,” Saeger says.
Thou shalt pay thyself first.
What used to be simple, sound advice is more of a commandment when $1 million or more is the goal. “If you make the financial plan first and then build your life around it, the outcomes are typically very positive,” says Mike Chadwick, CEO of Chadwick Financial Advisors in Unionville, Connecticut. “Most people do the opposite: They set up their life and then try to save after the fact, when it’s painful to do so. When something is paid off, save the extra money and you won’t feel the pain. And when you get raises, save the money until you’re on target.”
Avoid the temptation to spend first.
Most investors, especially in their younger years, think they can easily make up for copious spending and shopping. “This is certainly possible, but will require a potentially difficult, if not impossible, return on the investment or a significant increase in savings,” says Bellaria Jimenez, managing partner with MetLife Premier Client Group, based in Cranford, New Jersey. ”Investors must ignore temptations to spend and instead save.”
Patience, patience, patience.
Just as it takes years to get to retirement age, you’ll want to stick it out, as some investments hit expected bumps. “Over a typical working career, an investor can expect to experience at least eight to 12 poor market years,” says Jakob Loescher, a financial advisor with Savant Capital Management and based in Rockford, Illinois. “During these years, it’s important that the individual remain patient and not make any large market-timing mistakes.”
And finally, answer the $2.3 million question.
That’s how much money you’d need in 2045 to have the same purchasing power as $1 million today, assuming a 3 percent annual inflation figure. So how do you get to $2.3 million? “Assuming a starting account value of $50,000 and an 8 percent return on assets, an investor would need to deposit $13,500 at the beginning of each year over the next 30 years to achieve that result,” says Andrew Gluck, managing director of wealth management at GCG Financial.
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Pros and cons of buying a S&P 500 index fund
I've already mentioned some of the pros of index fund investing. The first is cost savings -- especially when it comes to S&P 500 index funds. In fact, the Vanguard S&P 500 ETF(NYSEMKT: VOO) comes with an expense ratio of just 0.05%. This means on a $10,000 investment, you'll pay just $5.00 per year in fees. Compare this to actively managed mutual funds, which can charge 1% or more, or to the often-astronomical fees hedge fund managers and investment consultants charge.
Another perk is that index investing is as low-maintenance of an investment strategy as you can find that has such strong long-term potential. Simply buy shares of your chosen fund, and let the market do the rest.
Index fund investing also takes emotion out of the equation. According to a study by Dalbar, the average investor's annualized returns were just 2.6% during the 10-year period from 2004-2013, approximately one-third of the S&P 500's annual return during that time period. This is mainly because emotion tells investors to do the exact opposite of what they should -- panic and sell when the market is falling, and buy when everyone else is at high prices.
The possible downside is that while you won't lose to the market, you aren't going to beat it, either. As I mentioned earlier, Buffett as well as other value investors are living proof that with the right research and know-how, it's possible to create a portfolio of undervalued stocks that can beat the market's return over long time periods. So, if you have the time to thoroughly research and value stocks, index investing may not be in your best interest.
It's not for everyone
Buying an S&P 500 index fund puts your investments on auto-pilot, and while you won't get rich quickly with this approach, you won't go broke, either. Nor will you pay thousands of dollars in fees to Wall Street investment managers along the way.
However, if you're willing to put in the homework to research and create a well-diversified portfolio of high-quality stocks to hold for the long term, go for it. That's what I do, and that's what The Motley Fool suggests for those who have the time and desire. The point is simply this: Whichever investment strategy you use to achieve them, one of your main goals should be to keep as much of your profits in your pocket as possible, and not in the pockets of hedge fund managers or high-fee investment consultants.
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NEW YORK, UNITED STATES: California Governor Arnold Schwarzenegger (L) cofers with billionaire investor Warren Buffet (R) during a meeting with Wall Street investors at the Ritz Carlton hotel February 25, 2004 in New York City. AFP PHOTO/POOL/Kathy WILLENS (Photo credit should read KATHY WILLENS/AFP/Getty Images)
CLEVELAND - MARCH 25: Philanthropist Warren Buffet (C) wears a LeBron James Witness tee-shirt as he cheers for the Cleveland Cavaliers during a game against the Denver Nuggets March 25, 2007 at The Quicken Loans Arena in Cleveland, Ohio. NOTE TO USER: User expressly acknowledges and agrees that, by downloading and/or using this Photograph, user is consenting to the terms and conditions of the Getty Images License Agreement. Mandatory Copyright Notice: Copyright 2007 NBAE (Photo by David Liam Kyle/NBAE via Getty Images)
Warren Buffett, chairman of Berkshire Hathaway Inc., right, speaks to David Rubenstein, co-founder and managing director of the Carlyle Group, during the Economic Club of Washington dinner event in Washington, D.C., U.S., on Tuesday, June 5, 2012. Buffett said he doesn't expect another U.S. recession unless Europe's crisis spreads. Photographer: Andrew Harrer/Bloomberg via Getty Images
DETROIT, MI - SEPTEMBER 18: Billionaire investor Warren Buffett speaks at an event called, 'Detroit Homecoming' September 18, 2014 in Detroit, Michigan. The purpose of the invitation-only event of Detroit expatriats is to give the group a chance to reconnect, reinvest and reinvent with their hometown. The topic of Buffet's conversation was, 'Why I'm Bullish on Detroit.' (Photo by Bill Pugliano/Getty Images)