2002: How would Buffett select an index fund?

AUDIENCE MEMBER: Good morning. My name is Tedd Friedman. I’m from Cincinnati, Ohio.

You said in the 1996 annual report that most investors will find that the best way to own common stocks is in an index fund that charges minimal fees.

Two questions. First: there are a lot of different index funds that hold different baskets of stocks. What criteria would you use, or recommend, to select an appropriate index fund?

Second: The price-to-earnings ratio of the S&P 500 is significantly higher than its historical average. What benchmark should an investor use in purchasing this index?

WARREN BUFFETT: Yeah, I would say that in terms of the index fund, I would just take a very broad index. I would take the S&P 500, as long as I wasn’t putting all my money in at one time.

If I were going to put money into an index fund in relatively equal amounts over a 20 or 30-year period, I would pick a fund — and I know Vanguard has very low costs. I’m sure there are a whole bunch of others that do. I just haven’t looked at the field.

But I would be very careful about the costs involved, because all they’re doing for you is buying that index. I think that the people who buy those index funds, on average, will get better results than the people that buy funds that have higher costs attached to them, because it’s just a matter of math.

If you have a very high percentage of funds being institutionally managed, and a great many institutions charge a lot of money for doing it and others charge a little, they’re going to get very similar growth results but different net results.

And I recommend to all of you reading — John Bogle’s written a couple of books in the last five years, and I can’t give you the titles but they’re very good books, and anybody investing in funds should read those books before investing, or if you’ve already invested, you still should read the books. And it’s all you need to know, really, about fund investing.

So I would pick a broad index, but I wouldn’t toss a chunk in at any one time. I would do it over a period of time, because the very nature of index funds is that you are saying, I think America’s business is going to do well over a — reasonably well — over a long period of time, but I don’t know enough to pick the winners and I don’t know enough to pick the winning times.

There’s nothing wrong with that. I don’t know enough to pick the winning times. Occasionally, I think I know enough to pick a winner, but not very often.

And I certainly can’t pick winners by going down through the whole list and saying, this is a winner and this isn’t and so on.

So, the important thing to do, if you have an overall feeling that business is a reasonable place to have your money over a long period of time, is to invest over a long period of time, and not make any bet, implicitly, by putting a big chunk in at a given time.

As to the criteria as to when you should or shouldn’t, I don’t think there are great criteria on that.

I don’t think price-earnings ratios, you know, determine things. I don’t think price-book ratios, price-sales ratios — I don’t think any — there’s no single metric I can give you, or that anybody else can give you, in my view, that will tell you this is a great time to buy stocks or not to buy stocks or anything of the sort.

It just isn’t that easy. That’s why you go to an index fund, and that’s why you buy over a period of time. It isn’t that easy.

You can’t get it by reading a magazine. You can’t get it by, you know, watching television. You can’t — you’d love to have something that said, you know, if P/Es are 12 or below or some number, you buy, and if they’re 25 or above, you sell.

It doesn’t work that way. It’s a more complex business than that. It couldn’t be that easy when you think about it.

So, if you are buying an index fund, you are protecting yourself against the fact that you don’t know the answers to those questions but that you think you can do well over time without knowing the answers to those questions, as long as you consciously recognize that fact.

And, you know, I would — if you’re a young person and you intend to save a portion of your income over time, I’d just say, just pick out a very broad index — I would probably use the S&P 500.

But I think if you start getting beyond that — starting to think you should be in small caps this time and large caps that time, or this foreign stock — and as soon as you do that, you know, you’re in a game you don’t know — you know, you’re not equipped to play, in all candor.

That would be my recommendation.

Charlie?

CHARLIE MUNGER: I think his second worry is that common stocks could become so high-priced that if you bought index funds, you wouldn’t expect to do very well.

I didn’t think I’d live long enough to think that was likely to happen, but now I think that may happen.

WARREN BUFFETT: But, probably what you’re saying there is they could get to a level and be at — they’d have to be at a sustained level like that for a long time.

CHARLIE MUNGER: They could be there and stay there for a long time.

WARREN BUFFETT: In which case, you might make 3 or 4 percent.

But would there be any way better than that around, under those circumstances, anyway? And pass the peanut brittle, please. (Laughs)

CHARLIE MUNGER: Well, in Japan, where something like this happened, the returns from owning a nice index over the last 13 years or so is negative.

Can something as horrible as that happen here? I mean, is it conceivable? I think the answer is yes.

WARREN BUFFETT: But the option in Japan, of course, is to have deposits in a bank, or own Japanese bonds, at somewhere between 0 and 1 or 1 1/2 percent.

So, if rates on everything get very low, which means stocks sell very high, you know, then it just means that you live in a different world than existed 20 or 30 years ago when, generally, capital got paid better.

CHARLIE MUNGER: I must say that we have very good packaging.

WARREN BUFFETT: Yeah. (Laughs)

Normally he does this in a less formal manner, but he’s on his good behavior today.

CHARLIE MUNGER: We’re protecting the integrity of the peanut brittle.

WARREN BUFFETT: That is true. The package — the nature of anything with butter in it, you know, is that it starts going downhill from the moment you make it. And therefore, the packing has to be extraordinary in order to meet the quality standards that Charlie and I insist on. (Laughter)