Invest in an index fund. Is that what Warren Buffett is saying?

The article on Warren Buffett last week caused a bit of a stir where he claimed that people were wasting their time trying to pick companies when they could be buying an index fund.

An index represents the average of all the returns in the market. Doesn't everyone want to be better than average? It just doesn't seem aspirational enough to aim for the average of anything.

An average golfer? An average quilter? An average driver?

If a room full of people are asked, "How many of you are above average drivers?" a lot more than half the room will put their hand up when only half should. That's what we would reasonably expect if human beings were any good at estimating their own driving ability.

Alas, we are often over-confident when it comes to assessing our own abilities. None more so than self-assessing our ability to pick winning companies to invest in.

Some of us might agree that we individually don't have the ability to pick winning companies to invest in, but our clever investment company should, or our clever broker does?

Not so. The experts are just as bad as anyone else. Forecasting which company is going to do better than another over the long term is as elusive as teeth on a duck.

Of course, year by year, a little under half the investors in a market will do better than the average (the 'little under half' is due to the costs of buying and selling), making a lie of Warren Buffett. It is over the long term that his claim comes into its own.

The investors that beat the market in any one year don't do it consistently year after year. Beating the market in any one year by picking winning shares and discarding losing shares is more due to luck than skill. The marketing boys at the big active managers will deny this fact until they are black and blue in the face but if you run their publically available results past the independent research fraternity they will confirm it time and time again. Winners don't persist over the long term at a rate greater than chance would predict.

A Nobel Prize winner put it rather well when he said that it only takes the power of addition and subtraction to prove that the average active investor will under-perform the average index fund investor over any given period. This is due to the impact of costs. Active investors spend more money on research than an index fund and as all the investors make up the market in the first place, the claim above is self-evident.

The active boys will then tell you that they are not 'average'; they are better than average. They all say that, and that proves the lie. Everyone can't be better than average, like our room full of "above-average" drivers, and in the long term, very few investment advisers/managers are better than average.

Warren Buffett's advice is to aim for consistently average investment returns through an index fund and take away the potential to be inconsistent. Consistency is the secret to building long term wealth. If you shoot the lights out this year, you must have taken extra risk and eventually this risk will come back and kill you.

Bad luck!

Keep asking great questions ...