One of the most common arguments that I hear

against index investing is Warren Buffett.

He is the centerpiece of many discussions

on stock picking, value investing, and dividend investing.

If stock picking doesn't work,

then why has Warren Buffett been so successful?

Warren Buffett loves dividend paying stocks.

Warren Buffett says that diversification

is protection against ignorance.

Buffett is a wealth of wisdom, knowledge, and experience.

He has also truly been one of the greatest investors

in modern history, based on his track record.

These are facts that cannot be disputed.

However, both Buffett's wisdom and his success

are often taken out of context

to support the idea that stock picking

is a smart investing strategy.

I'm Ben Felix, Portfolio Manager at PWL Capital.

In this episode of Common Sense Investing,

I'm going to tell you why Warren Buffett

is not a reason to pick stocks.

(bright music)

Fortunately for us, Warren Buffett documents his thoughts

on many topics in detail

in Berkshire Hathaway's annual letter to shareholders.

Let's start with Buffett's view on index investing.

As much as stock pickers

use Buffett as an argument for stock picking,

Buffett himself has long been a proponent

of investing in index funds.

In the 1996 letter to shareholders,

Buffett offered some investment advice.

Quote,

"Let me add a few thoughts about your own investments.

Most investors, both institutional and individual,

will find that the best way to own common stocks

is through an index fund that charges minimal fees.

Those following this path are sure

to beat the net results, after fees and expenses,

delivered by the great majority

of investment professionals."

In the 2013 letter,

Buffett explained the goal of the non-professional investor

should not be to pick winners.

Neither he nor his helpers,

Buffett is referring to stockbrokers

and high-fee fund managers,

can do that.

But should rather be to own a cross-section of businesses

that in aggregate are bound to do well.

A low cost S&P 500 index fund will achieve this goal.

That's a pretty clear message.

Now, I know what many of you might be thinking.

That only applies to non-professional investors.

If you dedicate enough time to it,

maybe you can be a professional too.

Let me offer some commentary

that Buffett does not mention in his letter.

There have been many academic studies

on professional investor's

ability to generate superior results.

I'll give you two of my favorite

and some quick quotes from their conclusions.

Mark Carhartt's 1997 paper

on persistence in mutual fund performance found, quote,

"The results do not support the existence

of skilled or informed mutual fund portfolio managers."

In their 2010 paper,

luck versus skill

in the cross-section of mutual fund returns,

Eugene Fama and Ken French concluded

through statistical analysis

that few funds produce benchmark-adjusted expected returns

sufficient cover their costs.

Suffice it to say

that even professional investors

have a tremendous amount of trouble

producing consistent risk-adjusted results

in excess of their benchmark.

Also in the 2013 shareholder letter,

Buffett goes on to explain

that investing in index funds is not enough.

You also need to maintain a disciplined approach.

Buffett concludes that with discipline,

the "know-nothing" investor

who both diversifies and keeps his costs minimal

is virtually certain to get satisfactory results.

Indeed, the unsophisticated investor

who is realistic about his shortcomings

is likely to obtain better long-term results

than the knowledgeable professional

who is blind to even a single weakness.

I don't know about you,

but I am far more comfortable managing my own investments

based on the assumption that I'm a know-nothing investor,

rather than assuming that I'm a knowledgeable professional

without blindness to even a single weakness.

Buffett also seems to think

that it is unlikely to find a knowledgeable professional

without blindness to even a single weakness.

Again, in the 2013 letter, Buffett gives us some insight

into how his estate assets

will be managed for the better it have his wife.

Quote,

"My money, I should add, is where my mouth is.

What I advise here is essentially identical

to certain instructions I've laid out in my will.

One bequest provides that cash will be delivered

to a trustee for my wife's benefit.

My advice to the trustee could not be more simple.

Put 10% of the cash in short-term government bonds

and 90% in a very low cost S&P 500 index fund.

I believe that trust's long-term results from this policy

will be superior to those attained by most investors

whether pension funds, institutions, or individuals

who employ high-fee managers."

Buffett similarly put his money where his mouth was

when he made a bet against Ted Seides

who was at the time the co-manager of Protege Partners,

a fund of hedge funds.

The bet was that Ted could not pick

five funds of hedge funds

that would beat Buffett's

Vanguard S&P index fund over 10 years.

The wager was not small either.

It was a $1 million bet.

Buffett won the bet in 2017 by a lot.

In his 2016 letter,

Buffett explained the many reasons that he was confident

that he would win the bet.

This is a quote from Buffett's initial challenge

to hedge fund managers.

"A lot of very smart people

set out to do better than an average in securities markets.

Call them active investors.

Their opposites, passive investors,

will by definition do about average.

In aggregate, their positions will more or less approximate

those of an index fund.

Therefore, the balance of the universe,

the active investors,

must do about average as well.

However, these investors will incur far greater costs.

So, on balance, their aggregate results after these costs

will be worse than those of the passive investors."

Buffett does add though

that some active investors will do well over time.

He explains, quote,

"There are, of course, some skilled individuals

who are highly likely to outperform the S&P

over long stretches.

In my lifetime, though, I've identified early on

only 10 or so professionals

that I expected would accomplish this feat."

Buffett's comment about early on is important.

It's very easy to identify a successful active investor

after they've been successful.

The real challenge is identifying

before they've been successful.

While Buffett believes

that there are some skilled investors out there,

he has only met 10 in his lifetime.

This speaks to the massive odds

that are against any active investor

and what I would call the overconfidence

of anyone who believes themselves to be

one of these extremely rare few.

Buffett concluded this section of the 2016 letter with this.

"The bottom line.

When trillions of dollars are managed

by Wall Streeters charging high fees,

it will usually be the managers who reap outsides profits,

not the clients.

Both large and small investors

should stick with low cost index funds.