Most investors dream of making their fortune on the stock market by picking one or more stocks that rocket upwards. Investors pursue this dream in different ways. In some cases, they just buy the ‘hot’ stocks of the day. Others are more diligent and spend time studying individual companies, analysing financial reports etc. After much soul searching, they invest in a select few.
In the normal course of events, some of these stock selections do well, others drift sideways and a few do poorly, but, in most cases, the overall performance of the portfolio fails to beat the market index. This is not a criticism of the average investor, as most professionals also struggle – a mere ten per cent of 2000 US stock funds beat their benchmark index in both 2011 and 2012.
Investors who manage to beat the market consistently are rare. These include the likes of Warren Buffett, George Soros and Peter Lynch. In his latest annual letter to the shareholders of Berkshire Hathaway (his investment vehicle), Buffett wrote, ‘The goal of the nonprofessional should not be to pick winners… the typical investor doesn’t need this skill.‘ He suggests that you can achieve satisfactory results by investing in a low cost S&P index fund. Such funds aim to achieve market performance and generally succeed in this objective.
Buffett is happy to match the performance of the S&P as this index includes 500 large companies representing a broad cross section of American business. He has great confidence in American industry, noting that ‘In aggregate, American business has done wonderfully over time and will continue to do so (though most assuredly, in unpredictable fits and starts). In the 20th century, the Dow Jones index ( a proxy for the S&P index) advanced from 66 to 11,947, paying a rising stream of dividends to boot. The 21st century will witness further gains, almost certain to be substantial.’
Buffett also intends to practise what he preaches. He is leaving much of his fortune to charity but he disclosed that his advice to the trustee looking after his wife’s inheritance is to place ten per cent in short term government bonds (the equivalent of cash but safer as they are backed by the US government rather than a bank) and the balance in a low cost S&P index fund. He goes on to say that he believes the returns from this approach will be superior to those attained by most investors – whether pension funds, institutions or individuals who employ high-fee managers.
It is clear that Buffett is a big fan of the market, but he does caution that the public have a tendency to enter the market at the wrong time, just after it has had a good run and the easy money has been made. He says the way around this kind of timing error is for an investor to accumulate shares over a long period of time (commit funds to the market on a regular basis e.g. monthly).