Index Funds: The Lesser Of Three Evils

TruePoint Capital

“In my view, for most people, the best thing to do is to own the S&P 500 index fund.” -Warren Buffett.

Warren Buffett doesn’t invest in index funds, so why would he recommend it for “most people?” I think what he’s saying is that for people interested in the stock market, they’re better off investing in an index fund than doing it on their own or hiring someone to do it for them. Why?

Because the average retail investor and Wall Street professionals rarely beat the market. So why try?

Warren Buffett is saying that if you want to invest in stocks, invest in an index fund because it’s unlikely you’ll get better results any other way.  

The S&P 500 is a widely accepted bellwether of overall market performance. It follows an index fund that invests in the S&P 500 companies should also track market performance closely. In other words, if you invest in an S&P 500 index fund, your investment will track the market average.

Investing in an index fund is the lesser of three evils because you will fall short of the market average if you attempt to invest on your own or through a professional. You’re better off with an index fund that will at least return the market average. Warren Buffett doesn’t invest in index funds because he doesn’t settle for average market returns. But his investments of choice are out of the reach of the average investor.

Warren Buffett prefers to invest in tangible assets with intrinsic value – assets that you can touch and feel and that have an underlying value. Tangible assets with intrinsic value have value independent of what the investing public is willing to pay for them.

In other words, no matter what the public thinks of a stock, as long as the underlying company is profitable, investors can take comfort in the fact that the company will continue to be viable because it provides a valuable product or service.

Why does Warren Buffett care about intrinsic value?

Because he cares about cash flow – in his case, cash flow in the form of dividends. Warren Buffett invests in companies that generate cash flow, which means that he has holdings in consumer electronics (Apple), airlines, soft drinks (Coca Cola), rail transport, recreational vehicles, manufactured homes, restaurants, furniture, and many others. These are all tangible assets, and they all generate cash flow.

Warren Buffett avoids Tech IPOs and speculative investments like crypto because of the intrinsic value factor. You can’t touch or feel them, and they don’t generate income. An investor’s only hope of achieving a return on investment is if someone downstream pays more than what you paid for it.

Why does Warren Buffett covet cash flow?

Because it compounds wealth. By leveraging the tremendous assets of his firm Berkshire Hathaway, Warren Buffett is often able to exact preferred stock from the companies in which he invests – giving him preferential dividends, voting rights, and sometimes a seat on the Board of Directors. This “activist investing” allows him to interact with the management of the companies he invests in and gives him a say in the direction of the companies in which he invests.

The average investor doesn’t have the capital or leverage to invest like Warren Buffett. They can never attain the type of preferred stock that Warren Buffett can demand.

In other words, the average investor can’t play in Warren Buffett’s playground. That’s why he tells them to invest in an index fund. He’s saying the index fund is the best the individual investor can do.

Still, many investors don’t realize that it’s possible to invest like Warren Buffett without the large capital requirements. You have to look for what Warren Buffett looks for. And what exactly is he looking for?

Here are the basic elements of a Warren Buffett target investment:

  • Cash Flow.
  • Tangible Asset.
  • Long-Term Growth.
  • Access to Management.

You can invest like Warren Buffett, but you won’t find these opportunities on Wall Street. They can be found in the private markets where opportunities to invest in tangible assets like real estate or cash-flowing businesses abound – offering all the essential elements Warren Buffett seeks for creating and growing wealth.

An equity investment in a private company backed by a hard asset that cash flows and offers long-term growth gives the individual investor the same opportunities to build and grow wealth that Warren Buffett enjoys.

But what about access to management? Why is that important?

Warren Buffett wants to make sure his investment objectives are compatible with those of the companies he invests in. He can exact this access to management by leveraging his substantial resources. With private investments, accessibility to management is a cornerstone of these types of investments. Management makes themselves available to answer questions because it is often the managers doing all the capital raising.

If you want to invest in stocks, don’t waste time doing it yourself or hiring a professional. You’ll get average results by investing in an index fund. But should you settle for average? Warren Buffett doesn’t, and neither should you.

Private market offerings provide investors who may not have the same deep pockets as Warren Buffett the same opportunities to achieve financial independence.

This is done through assets that cash flow and appreciate – all backed by a tangible asset that provides transparency and access to management that allows investors to align their investment objectives with management.