Warren Buffett is happy to share investment advice with anyone who's interested. His annual letters to shareholders and extended question-and-answer sessions at Berkshire Hathaway's annual meetings are incomparable sources of wisdom.
Buffett has been a great guide for countless successful investors who like to pick great companies, not just great stocks. But the Oracle of Omaha's top recommendation for most investors is to ignore a lot of that and keep things as simple as possible.
That's because it's often the behavioral challenges of investing in individual companies that trip up those who would otherwise be successful. Buying or selling a great company at the wrong price at the wrong time is a path to underperformance.
Here's what Buffett recommends instead.
Image source: The Motley Fool.
The only investment most people need
One of the easiest ways for investors to avoid the behavioral tripwires that can lead to lagging the stock market is to stop trying to outperform the market average in the first place.
That's why Buffett's top recommendation for average investors is to put money in an index fund. He prefers the Vanguard S&P 500 ETF (VOO 1.77%). Buffett plans to take his own advice, too. He instructed the executor of his estate to put 90% of his wealth in the index fund after his passing.
If you consistently put aside $500 of your paycheck every month, you could be sitting on a six-figure portfolio 10 years from now, even if you're starting from nothing.
Buffett doesn't think dollar-cost averaging is for active stock pickers. While he doesn't try to time the market, he does try to value companies. Buying a company's stock without regard for its value (as dictated by a dollar-cost averaging strategy) won't lead to the outperformance stock pickers seek.
But when it comes to passive investing, the best way to get the most out of your money is to put all your money into the fund and consistently add to it over time with money from your earnings. Earning average returns for a long time can produce above-average wealth.
How $500 per month can create a six-figure portfolio
The S&P 500 expanded to a 500-constituent format in March of 1957. Since then, the broad-based index has gone on to produce a compound average annual total return of 10.5%. That return is achieved by reinvesting dividends, which most brokerages allow you to do automatically.
If you set up a brokerage account and automatically purchase $500 of the Vanguard S&P 500 ETF every month while reinvesting dividends, here's what you can expect if you earn average returns from the last 70 years.
| Years Investing | Expected Value of Portfolio |
|---|---|
| 1 | $6,335 |
| 2 | $13,335 |
| 3 | $21,068 |
| 4 | $29,611 |
| 5 | $39,050 |
| 6 | $49,477 |
| 7 | $60,998 |
| 8 | $73,726 |
| 9 | $87,788 |
| 10 | $103,324 |
Calculations by author.
It's worth pointing out that $500 per month, or $6,000 per year, is less than the annual contribution limit for an IRA. That will ensure you keep your investments tax-deferred or even tax-free. While the Vanguard S&P 500 ETF doesn't have a history of capital gains distributions, investors still have to pay taxes on its income distributions from dividends. Those usually incur a 15% qualified dividend tax, so there's a slight tax drag. But even if you set aside 15% of each dividend distribution, you could end up with a portfolio value north of $100,000 based on average returns.
If you contribute the $500 per month to an employer-sponsored retirement plan, you could end up with well over $100,000. That's because most plans include a matching contribution. While you might not have the Vanguard fund available in your plan, most include some low-cost index funds. Even with relatively high fees, that can be the easiest way to build a sizable portfolio for retirement.
Charlie Munger, Warren Buffett's Vice Chairman and longtime friend, once told a young investor that the first $100,000 is the hardest. (He used more colorful language.) Once you have $100,000, you can let off the gas a bit because the returns from the portfolio will start to do some of the work for you.
Indeed, if all you did was invest $500 per month for 10 years like above and let it sit for another 10 years, you'd have close to $280,000 without adding another penny. Wait 15 more years, and you'll have around $1.25 million. That's the true power of compounding, and it doesn't take any special skills or market timing knowledge to get there.
