Skip to main content

NEW YORK (TheStreet) -- Earlier this week Warren Buffett drew a lot of media attention for his long standing belief that most investors are better off just owning an index fund, specifically the Vanguard S&P 500 Index Fund (VFIIX) - Get Free Report.

This came up again after a letter of instruction reported by the Washington Post to be part of his will surfaced with direction of how to allocate his wife's inheritance.

From Buffett:

"Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard's.) I believe the trust's long-term results from this policy will be superior to those attained by most investors -- whether pension funds, institutions, or individuals -- who employ high-fee managers."

Of course many investors do not simply put all of their equity exposure into an index fund for a variety of reasons including the belief they can beat the market which some do, enjoyment of time spent on the task, feeling the need to manage to a specific outcome like higher dividend yields or lower volatility and even simply wanting to gamble in the stock market.

An even bigger proponent of indexing is of course Jack Bogle who founded the Vanguard Group and while most readers of TheStreet are not indexers it is important to understand the fundamental argument of indexing so that when an investor chooses to engage markets more actively does so as a more informed participant.

Most active investors do not outperform the market. The Standard & Poor's Indices vs. Active Funds keeps tabs on active manager performance and it recently reported that for the year ending June 30, 2013, only four of 10 active managers outperformed and the numbers go down from there when considering outperformance over multiyear periods. Investors who are exceptions tend to be famous billionaires like Stanley Druckenmiller and Buffett himself.

The average annual return of the S&P 500 varies depending on the time observed. According to the average annual return for 50 years is 10.22%, for 25 years it is 10.52% but for ten years it is just 7.36%.

The building block of understanding with these numbers is that even the 7% number can be enough to grow a nest egg that is suitable for retirement provided that result is combined with an adequate savings rate. Arguably, savings rate is more important than returns because investors have more control over their savings rates than they do over what the market does.

An investor needs to consider that if they put their money into a broad based index fund like VFIIX or the iShares Core S&P Total Market ETF (ITOT) - Get Free Report then the odds are they will achieve a better result than if they work full time on their portfolio trying to outperform that broad based index. That should be reason for some portion of investors who are now actively engaged to switch.

Of course beating the market is not the objective of every participant. A suitable objective for the very wealthy is preservation of capital in conjunction with a growth rate that paces inflation. Many investors in the withdrawal phase of retirement planning focus on dividend strategies to meet income needs but investors still in accumulation phase need to consider the possibility they would be better off as passive investors.

At the time of publication the author held no positions in any of the stocks mentioned.


This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.