12/25/2007 10:13 pm ET Updated May 25, 2011

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


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.


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.