Why Warren Buffett Thinks You Need to Invest in S&P 500 Index Funds

Warren Buffett smiles during an interview. He thinks the average investor should invest in the S&P 500 index fund.
Berkshire Hathaway Chairman and CEO Warren Buffett smiles during an interview in Omaha, Neb., on May 7, 2018. Buffett thinks the average investor should invest in the S&P 500 index fund. Nati Harnik / AP Photo

Warren Buffett is arguably the most successful stock picker on the planet. But that doesn’t mean he thinks you should pick your own stocks.

The Oracle of Omaha thinks the average investor should seek to “own a cross-section of businesses that in aggregate are bound to do well,” he wrote in his 2013 Berkshire Hathaway annual letter to shareholders. “A low-cost S&P 500 index fund will accomplish this goal.”

Buffett believes in S&P 500 funds so much so that he’s directed the trustee of his estate to invest 90% of his money in S&P 500 funds for his wife when he dies. The remaining 10% will go to short-term Treasury securities.

Here’s the 411 on S&P 500 index funds and why Buffett loves them so much.

What Is an S&P 500 Index Fund?

The S&P 500 is a stock index that tracks the performance of stocks issued by 500 corporations in the U.S. (There are actually 505 stocks in the S&P 500 because five of the companies — one of which is Buffett’s Berkshire Hathaway — issue two classes of shares.)

It’s the most widely tracked stock index in the U.S., followed by the Dow Jones Industrial Average and the Nasdaq. When you hear in the news that stocks rallied or stocks plunged, often that means that the overall prices of those 505 stocks in the S&P 500 trended upward or downward.

An S&P 500 index fund is a pool of stocks designed to track the S&P 500. When you buy a single share, you’re automatically invested across all 500 companies. When the S&P 500 is up, the value of your investment increases; when the index is down, your investment will be as well.

You can find S&P 500 funds that are exchange-traded funds (ETFs), which are traded like individual stocks on stock exchanges, or mutual funds, which you buy from an investment company.

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The Pros and Cons of Investing in an S&P 500 Index Fund

Here are the pros and cons of S&P 500 index funds. Spoiler alert: There are a lot more pros than cons, especially if you’re a beginning investor.

S&P 500 Index Fund Pros

  • With a single investment, you get an automatically diversified portfolio. That’s a fancy investor way of saying you spread out your risk instead of putting all your eggs in one basket. You’re invested in 500 companies across 11 different sectors. That’s why investing in an S&P 500 index fund is a lot less risky than investing in stocks of individual companies.
  • The S&P 500 produces reliable long-term returns. Over the past 30 years, the S&P 500 has delivered average annualized returns just shy of 8% after you factor in inflation. That doesn’t mean you can’t lose money. The S&P 500 fell more than 50% during the Great Recession of 2007 to 2009. But historically, the index has rebounded over the long term.
  • Their fees are minimal. Because you’re not paying for professionals to handpick investments for you, investment costs are low. Many S&P 500 index funds have an expense ratio of less than 0.1%, meaning that less than 0.1% of your investment is spent on non-investment costs. If you invest $1,000 in a fund with a 0.1% expense ratio, $999 of your money will go toward the actual investment.
  • Passive management typically beats active management. Don’t let the idea of sitting back and letting your money roll with the overall S&P 500 scare you. After fees, most active managers underperform index investing, which is often referred to as passive management.
  • You’re investing in major corporations with a profitable track record. To be included on the S&P 500, a company needs to have an $8.2 billion market capitalization, which is the total outstanding value of all its shares. They’re also required to have at least four consecutive profitable quarters under their belts. If a company runs into financial trouble, it risks being delisted.

S&P 500 Index Fund Cons

  • There’s less potential for big rewards. A drawback of investing in any index fund is that you don’t have the potential to hit the jackpot by picking the next Netflix. You also won’t outperform the market, because the fund’s performance goes hand-in-hand with the S&P 500’s performance.
  • The S&P 500 is heavily concentrated on a few giants. Yes, you become an investor in 500 corporations when you buy an S&P fund. But because the index is weighted by market cap, your money isn’t distributed evenly across those companies. Just five tech companies account for 22% of the S&P 500’s value: Apple, Microsoft, Amazon, Facebook and Google parent company Alphabet. While these companies’ share prices have been soaring, there’s also the risk that if the tech sector falters, it could disproportionately affect the overall index.
  • Giant corporations have less room for growth. The companies in the S&P 500 are among the most successful and stable in their respective industries. One downside to that: They’re already so big that they have less room to grow. Small-cap stocks, or those with a market cap under $1 billion, usually have the most growth potential, though they’re also a lot riskier.

What Is the Best S&P 500 Index Fund?

There’s no “best” S&P 500 index fund. They’re made up of the same investments, so they pretty much deliver the same returns. And you don’t need to own more than one S&P 500 index fund since they all track the same index.

The main thing you should focus on is low fees. Look for an expense ratio of 0.1% or less. Choosing a fund with a low minimum upfront investment is also a good bet. With ETFs, the cost to start investing is the price of a single share, whereas mutual funds often require an upfront investment of $1,000 to $2,000.

Some options we like in no particular order include the SPDR S&P 500 ETF Trust (SPY), S&P 500 Index Fund (SWPPX), iShares Core 500 ETF (IVV) and the Fidelity 500 Index Fund (FXAIX).

A final tip from Mr. Buffett: Don’t invest all your money at once. Practice dollar-cost averaging, which means you make regular investments at fixed intervals, which usually gives you the best price on your investments in the long term.

Robin Hartill is a certified financial planner and a senior editor at The Penny Hoarder. She writes the Dear Penny personal finance advice column. Send your tricky money questions to [email protected]