Buffett's message for first-time investors: Stock picking is hard, buy an index fund

By Morningstar |  28-06-21 | 

A sane money approach isn't complicated, as Warren Buffett noted in his annual letter to Berkshire Hathaway shareholders earlier this year: All that's required is the passage of time, an inner calm, ample diversification, and a minimisation of transactions and fees.

The biggest lesson for first-time investors: The average person can't pick stocks; most investors would benefit from purchasing an index fund over the long term.

The best thing for first-time investors is to be in the market, and not fall for investing themes.

The main thing to do is to be aboard the ship. A ship. You couldn’t help but do well if you just had a diversified group of equities (US equities would be my preference) but to hold over a 30-year period.

There's a lot more to picking stocks than figuring out what’s going to be a wonderful industry in the future.

To illustrate this point, Buffett said investors are attracted to popular industries, whether that be railways in the mid-1950s or tech companies today. But picking the winners and losers in an industry is incredibly difficult. For example, in 1903 the "place to be" was the auto industry. The thesis was that someday 290 million cars would be buzzing around the U.S. At least 2,000 companies entered the auto business. In 2009, three were left, two of which went bankrupt.

 The Maytag company put out a car. Allstate put out a car. DuPont put out a car. There was Nebraska Motor company. Everybody started car companies just like everybody is starting something now that can be where you can get money from people.

But there were very, very, very few people that picked the winner.

Should long-term Berkshire shareholders continue holding their stock or diversify their risk across an index?

The question was asked with reference to the underperformance of Berkshire Hathaway's stock with respect to the S&P 500 index (-18.48% in CY20).

I recommend the S&P 500 index fund, and have for a long, long time, to people.

I’ve never recommended Berkshire to anybody, because I don’t want people to buy it, because they think I’m tipping them into something I’d never. No matter what it was selling for. And I’ve made it public. On my death, there’s a fund for my then-widow, and 90% will go into an S&P 500 index fund, and 10% in bonds.

I like Berkshire, but I think that a person who doesn’t know anything about stocks at all, and doesn’t have any special feelings about Berkshire, I think they ought to buy the S&P 500 index.

Investing is not an easy game.

Buffett took time to remind investors, particularly newer investors, of the extraordinary things can happen in stock markets. To illustrate this, he ran a list of the 20 largest companies in the world by stock market value (March 31, 2021). Apple was number one with just over $2 trillion - LVMH Moët Hennessy Louis Vuitton at number 20, worth around $330 billion.

Looking back at the top 20 from 1989, Buffett noted that none of the top 20 today appeared on the list 30 years ago.

None. Zero. There were then six US companies on the list and their names are familiar to you. We have General Electric, we have Exxon, we have IBM Corp. None made it to the list 30 years later.

Buffett then invited the audience to think about how many of these companies will still be on the list in 30 years.

It’s not going to be all 20. It may not even be all 20 today or tomorrow.

The lesson for investors is that the world can change in very dramatic ways. Don't get too sure of yourself.

We were just as sure of ourselves as investors and Wall Street was in 1989 as we are today, but the world can change in very, very dramatic ways.

20 largest companies by market cap (click on the image to enlarge)


Source: Berkshire Hathaway AGM, Bloomberg, EQS Function

 The itals refer to Warren Buffett's quotes.

This post has been extracted from a more detailed write up by Emma Rapaport from Morningstar Australia.

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