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Why Warren Buffett advocates index funds

Warren Buffett is almost universally known as the greatest investor of all time. The Oracle of Omaha has been the chairman and CEO of Berkshire Hathaway (NYSE: BRK.A) since 1964. He actually purchased Berkshire Hathaway, which was a failing textiles mill at the time, out of spite – the former owner had short-changed a young Buffett on a deal and in revenge, Buffett bought the company out from under him.

Since that time, Buffett has transformed Berkshire from a failing business into an investing behemoth – a US$517 billion conglomerate with major stakes in a huge variety of US businesses – including Apple, Coca-Cola, American Express and Bank of America. He was able to do this by achieving an average rate of return north of 20% per annum since 1964, more than double the market average.

And yet, his best piece of investing advice for ‘most people’ is to just buy into an S&P 500 index fund. Nothing more, nothing less.

So why is the greatest active investor ever telling most people that they shouldn’t even try to do what he does?

Well, because most people aren’t him, for one. But that’s a cop out. There are plenty of investors who do very well for themselves, outperforming your typical index funds. But many more don’t – there are statistics that show that the majority of investors who try investing and stock picking themselves (as well as fund managers) do not achieve this.

There are many reasons why – some people get scared when their shares drop and sell at the wrong moment, or otherwise overpay for companies that they should have waited for a better price on. Others just don’t research or understand the businesses they are buying.

Human emotions get the better of most investors at some point in their investing lives, and that’s why Warren Buffett thinks that most of them would be far better just buying the market and going along for the ride.

Foolish takeaway

I think that Warren Buffett has a very profound point. Many investors do end up doing the wrong thing, lose some money and then, instead of learning from their mistake, give up. Others repeat mistakes, get emotional and consistently underperform the market.

Of course, you won’t really know if you’ve got what it takes until at least a few years in, so a good strategy might be to hedge your bets – invest in an index fund like iShares S&P 500 ETF (ASX: IVV) or even a local version like the Vanguard Australian Shares Index ETF (ASX: VAS) alongside some individual stock picks and see what happens.

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Motley Fool contributor Sebastian Bowen has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.