Smart Advice for the HuffPost Investor: Warren Buffet on Index Funds, the Truth on Investment Professionals, and the Falling Dollar

What are Warren Buffett's views on index funds?

Will "investment professionals" say anything to get your business? Some of them will try to convince you that actively managed funds are more tax efficient than index funds.

Is this fact or fiction?

Why is everyone so convinced the dollar will continue to decline? Do they already know tomorrow's news?

I deal with these issues in this week's column.

Your questions are excellent. Please add them as Comments to this blog.

Question from Chris:

Mr. Solin, You constantly hammer home index funds and diversification. Tell me was Warren Buffett wrong? "Wide diversification is only required when investors do not understand what they are doing." -- Warren Buffett

Chris,

Warren Buffett is right (as usual).

Here are his views on index funds:

• : "...the best way to own common stocks is through index funds..., 1996 Investment Letter to Shareholders;
• "Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals." 1997 Investment Letter to Shareholders;




• "...those index funds that are very low cost (such as Vanguard's) are investor friendly by definition and are the best selection for most of those who wish to own equities." 2003 Investment Letter to Shareholders;




• "Over the [past] 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous." 2004 Investment Letter to Shareholders.

I also agree with the quote you attribute to him.

Most investors don't know what they are doing. They buy actively managed funds, engage in stock picking, market timing, manager picking and chase returns.

Investors without Bufett's expertise and assets would be well advised to follow his advice and buy index funds.

Market returns are superior returns. They are yours for the taking and they would put you in the top 5% of all professionally managed money based on historical data.

That's why I constantly "hammer home" index funds and diversification.

Question from jruben18:

Money managers always point out that if you are in a high tax bracket you should use their services as stock index and bond mutual funds do not try to be tax efficient. Your thoughts?

The money managers giving you this advice are acting irresponsibly.

Index funds are significantly more tax efficient than actively managed funds.

Taxes are generated by portfolio turnover. Turnover generates capital gains, dividends and interest, all of which result in taxes (both ordinary income and capital gains) that must be paid by fund investors.

Large cap index funds typically have a turnover rate of 7% or less.

Actively managed funds can have turnover rates that are significantly higher. For example, the Morgan Stanley Growth C Fund had a turnover rate of 21% and the flagship Fidelity Magellan Fund had a turnover rate of 74%, in 2006.

Vanguard founder John Bogle did a study of the amount that investors got to keep net of taxes and other costs over a sixteen-year period. Investors in actively managed funds retained only 47% of their cumulative returns. Investors in index funds kept 87% of their returns.

When you read about those wonderful returns reported by actively managed funds, you are seeing pre-tax returns. The story would be very different if they were required to report after-tax returns.

On study compared after tax returns of actively managed funds with those of index funds over a ten year period. It found that the index funds outperformed 97% of the actively managed funds.

"Investment professionals" who tell you that index funds are not more tax efficient than actively managed funds are either woefully ignorant of the facts or are deliberately misleading you.

Question from TrollDiddy:

Dan, I love your column. There's a lot of wackos who blog on this site and you aren't one of them.

My situation:

I live in Poland right now and am paid in USD. As I'm sure you know, the dollar is currently taking a beating against currencies around the world. This includes, unfortunately for me, against the Polish zloty.

I have to pay rent, car insurance, food costs, utility costs, etc., in zloty.

Currently I have ample disposable income. I generally follow your advice and invest in my 401(k) and also with Vanguard index funds. I also "play" with some stocks in my Ameritrade account, but I learned a hard lesson lately when one of my "basket of eggs" shattered on the street and I'm switching to more diversified fund options.

I also have a savings account.

My question is this: given the likelihood that the dollar will continue to decline for the foreseeable future, how much of my money should I devote to allocating to Polish zloty? Say, maybe I should put 10-20% of my monthly income into my Polish savings account and just enjoy the "increase" in money by not decreasing with the value of the dollar?

NOBODY can predict the future of money, but I want your insight. Thanks.

TrollDiddy,

I appreciate your kind words about my column.

You are correct that no one can predict the future of currency fluctuations. It is important to note that current valuations already take into consideration all of the economic news that is available to the public. Therefore, it would be a mistake to assume that today's dismal news will continue to adversely affect the value of the dollar.

Since you are living in Poland, and being paid in dollars, it seems to me that it would be prudent to put 10%-20% of your monthly income into your Polish saving account because your consumption will be in zlotys.

Your investment portfolio should still be a globally diversified portfolio, with an appropriate asset allocation, and the use of index funds, passively managed funds or Exchange Traded Funds. This portfolio will give you additional protection against fluctuations in any single currency.

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein.

Comments

[Herm]

Dear sir,
Pardon my cynicism, but please comment on index funds and their vulnerability to being hijacked by Wall St. and big banks. I am referring to what may be the last place a small investor looking for a way to save for retirement, or other worthy cause, is being pushed by just about everyone in the financial advisory community as perhaps the one safe place a small investor can put his money.

Since central banks and debt manipulation became the defining entities upon which the world would operate, every scheme presented to small investors has been violated in one form or another by the aforementioned Wall St. and big banks. Or, more correctly, the small investor has been violated - and in most cases, stolen from. The theft continues as movement in the pipeline occasionally gets to class action suits. Sometimes there is a settlement - and the lawyers get most of those funds. Please comment.
Thanks
Herm

[CharlesMac]

Some folks may be familiar with the popular phenomena of J.J. Cramer. He enjoys some renown as a stock picker, but is probably better known as a knowledgeable entertainer with an adrenaline addiction. He has put many years into Wall Street and now finds himself on his own show, where he makes 15 second buy/hold/sell stock recommendations to callers.

The man is the antithesis to the sage Warren Buffet.

Yet, I am a fan of the guy. As a person, not as the madman you see on TV. The reason is that in '99, when the markets had progressed to whatever is beyond insanity, I heard him speak at a small fundraising event. He gave advice which I could not believe I was hearing from a man who made his living on Wall Street and as a stock picker...

1) (summarized) You are not as smart as you think you are. Wall Street and the market are making you think you are. When this "run" collapses, and it will, try not to think you are stupider than you really are. You are being handled by some greedy people, who are very good at what they do.

2) Stocks are not companies, companies are not stocks. No matter how irrational a stock price might be, it will always find its way back to the true valuation of the company.

He ended up very correct by the end of 2000.

3) Most people will best benefit from a lifetime of investment in low maintenance cost index funds. "'Most people' means you, and you...."

There were 20 tables in the hall, and he pointed to all 20.

#3 was unimaginable at the time, and for this audience of people who were far above modest means (not me) and paying large amounts of money to the most prestigious investment firms.

It is my understanding that Cramer has repeated the sage advice on index funds in his latest book.

As Mr Solin points out, Warren Buffet is always right.

Even good men hampered by an adrenalin addiction have to agree.

[Troubledgoodangel]

The falling dollar is a consequence of America's scrambling to be competitive on the world markets! It's a global tragedy when one realizes that, against China, which we propped up, we can never be competitive again! Why? Because, even if China adopts the dollar or euro as its currency, China will still produce much cheaper due to its unlimited work force ... and our know-how! What is now transpiring, is that China is becoming the only World Market-Holding Power, while America and the world is becoming the subservient Customer of China! This dynamic, in itself, makes the dollar less and less relevant!

[Halsey]

I see a lot of talk about index funds..and yes..I'm a dreaded financial advisor..and use..oh about 75% of client's assets in Index (buy and hold) funds..BUT...if you just stick with the S & P 500..you're screwed...for the first time in 6 years, charts, and fundamentals (Dan, you can corraborate this)..you are better off in Cash (money market) than in the S & P. Does this mean I go to cash..no.. but..one also must buy the index's of France, Germany, Sweden ..and right now..I like S. AFrica... and, sometimes, unless you're Mr. buffett...you need some help in allocating globally. I could never analyze the stock from an individual company in S. AFrica..but I can sure buy their index..

by the way..I'll be hanging on to the Apple I started buying at $39 (and still buy..yes..even at $200)..and Google..that I woke up and finally started buying at $350...

[realitytrumpsbull]

How about 'I won't be investing in anything
until they clean up their lending practices'?

[gerrylong]

Response to Tranquilhorizons:

Ron Paul's position on U.S. warmongering and empire building is correct. It all should be reversed.

But Ron Paul's position on "reducing the size of government" -- more de-regulation, is goofy. We've been living with that philosophy since the days of Ron Reagan, the King of Deregulation.

Example: In deregulated the airwaves, Reagan eliminated the "fairness doctrine", giving birth to the wretched group of hate mongers such as Limbaugh, O'Reilly, Beck, Ollie North, etc., and the country is more divided than ever in its history. The '94 GOP controlled congress made the drug-addicted, loud-mouthed liar Limbaugh an honorary member of congress.

The current White House dim-wit has continued those policies, and we have all federal agencies reduced to toothless entities, unable to protect our food, drugs, air, water, and health and safety.

The GOP is controlled by a pack of rich thieves who give not a damn about the country, but only about the party and their own net worth. Otherwise they would impeach Bush, the most corrupt president in our history.

Ron Paul will play into the hands of those same thieves.

[salvesons]

Why are Index Funds treated as if the stocks in their portfolio are not "picked"? Low fees, low turnover, and diversification are the benefits, sure, but pretending that there is somehow no "stockpicking" going on in them is a misconception. The S&P 500 is picked...by the S&P committee who adds or kicks out the stocks in the index. I've seen that committee make really stupid picks. Why did they own Worldcom in 2000-2002, only to watch it fall to pennies until finally kicking it out of the portfolio at around $1.50? Its best to realize that there is always stockpicking going on.

[Deecarda]

Mr. Solin, please, I need some guidance. My mom recently passed away & left me the beneficiary of her insurance policies. I am having a hard time dealing with my sorrow, and I feel guilty for leaving this money earning approx 3% due to my inability to make any financial decisions. I just don't know what to do & am skeptical of financial counselors in the marketplace. Can you offer any advice?

[TheLar]

Hey Dan! It's great to see this down-to-earth advice on HuffPo. A couple questions:

1. In keeping with a broad and general view of HuffPo's values (which I share deeply) what is the best way to invest ethically? For example, there is much mention of Fidelity divesting its investments in Darfur. I also tend to avoid international funds and oil because international businesses do not always respect basic human rights and worker rights. Also, the oil industry's misdeeds are well known. Any advice on ethical investing for the common man? (i.e. Not Warren Buffet?)

2. How do you feel about retirement targeted funds? Speaking of Fidelity again, they have "Freedom Funds 2030" for example. The goal being they manage your money with the understanding you intend to retire in 2030. Thoughts?

Your advice is very much appreciated!

[SpyvsSpy]

Love the commentary, Dan. Keep it up.

Just read something by Scott Burns on MSNMoney suggesting a non-standard allocation that cuts risk but keeps up with market returns. Would be very interested in your opinion.

Here's the quote:
"His two-asset portfolio -- 50-50 U.S. large- and small-cap stocks -- produced an annualized internal rate of return of 10.74%. But it lost a deadly 30.8% in its worst year. His seven-asset portfolio -- equal portions of U.S. large- and small-cap stocks, international stocks, U.S. intermediate fixed-income investments, cash, REITs and commodities -- provided an 11.25% return. But the worst-year loss was only 10.2%".

So whaddya think? Does an allocation like this make more sense that a conventional 70/30 stock/bond mix for a self-directed mid-fifties buy and hold investor?

Interested in your opinion. Thanks.

[TwinsFanatic]

You say to post a question here, so:
My wife and I bought an investment condo 3 years ago with an adjustable mortgage that will change 2 years from now. We got a superb rate (5 1/2 percent), and right now, the rent we're getting is breaking even with our mortgage payments, so we'll be fine for another few years. But when the rate recalculates in two years, we will start losing money. If we sell now, we"ll probably take a slight loss on the property, but if we hold, obviously who knows what might happen¦ Any thoughts?

[deminmo]

Some experts predict we will slowly grow a
stronger economy in 2008. And others suggest
2008 will be a long difficult year, as with
housing and lending this year, and that a bad
recession is coming? What trends do you see?

[ReasonIsMyReligion]

No conversation about market returns can be made without a sentance about RISK, and each investor's individual capacity for same.

Buffet can afford to lose $1M. I cannot.

(Good educational stuff, and risk survey, on www.ifa.com . And no, I have no relation with them whatsoever. Free plug.)

[ReasonIsMyReligion]

As to the question re getting paid in USD vs. Zloties, another question:

Even assuming efficient markets -- for currency exchange in the moment -- isn't there some sort of parallel with FUTURES markets?

TrollDiddy is getting paid in USD TODAY. Dollars trade with zloties at some rate TODAY. Were he to be paid in some market-set forecast of the exchage rate NEXT year, the boss might indeed have to cough up more DOLLARS. e.g. Pork bellies sell for $X. PB FUTURES might sell for $X+ at some date certain in the future.

(Also, his contract may not contain any indexing to the exchange rate vis-a-vis the country in which he is employed.)

[ReasonIsMyReligion]

Name me ONE Nobel Prize winner in Economics for picking fund managers, individual stocks, market timing, etc.

On the other hand, a good number of Nobel Prize winners have done so simply by debunking the snake oil salesmen.

Read on:
http://www.ifa.com/12steps/step5/#5q

"" By day we write about "Six Funds to Buy NOW!"... By night, we invest in sensible index funds. Unfortunately, pro-index fund stories don't sell magazines. "
Anonymous Fortune Magazine Writer, Fortune, April 26, 1999
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