He said it again. Yes, Warren Buffett, one of the greatest active investors of all time, thinks indexing is a good idea for most folks. The Oracle of Omaha gave index funds a plug in a new article in Fortune.

The story’s writer, the estimable Ben Stein, recounts a recent conversation with Buffett:

“What should a typical upper-middle-class person in the U.S. buy to prepare for retirement?”

“Equities,” Buffett answers without a moment’s hesitation.

“The VTI?” I ask.

“That’s good enough. Maybe a selection of high-dividend-paying stocks that are likely to raise their dividends. Maybe the top 100 dividend payers of the S&P 500.”

Then, after a second’s thought, he adds, “Well, maybe not that, but equities.”

VTI is the ticker for the Vanguard Total Stock Market ETF, a large cap fund that tracks the MSCI U.S. Broad Market Index. It’s not the first time that Buffett has recommended indexing. In 2007, for instance, he advised that “a very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money.” Buffett has made similar recommendations at least twice in the annual reports of his firm, Berkshire Hathaway.
Why would one of the world’s great investing minds advocate that investors employ a strategy that’s the antithesis of Buffett’s extraordinarily successful investment process? Simple, really. Although the CEO of Berkshire Hathaway Inc. is too modest to say so in so many words, he’s effectively telling us that there’s only one Warren Buffett.
Yes, a relative handful of investors will beat the indices by a wide margin. But the overwhelming majority will earn average returns, perhaps below average after factoring in taxes, trading costs, and all the usual hazards that bedevil investing decisions in real time. The key question, then, is: How much will you pay for average returns? Using the best index funds ensures that you’ll pay rock bottom prices. VTI, for instance, charges a mere 7 basis points, or seven-hundredths of one percent. That compares with around 100 basis points, or 1% of assets, for the average actively managed U.S. stock fund. That doesn’t sound like much, but it adds up over time, and it’s a performance drag that’s difficult for most active funds to overcome in the long run.
Of course, it’s misleading to think that simply buying and holding one U.S. equity fund is all there is to enlightened money management. That basic strategy may work, of course, but it might not. In a world where the future’s always uncertain, diversifying across multiple asset classes is the only game in town short of embracing an unusually high level of risk by betting the farm on one stock, one fund, or one asset class.
The good news is that there’s a rainbow of index funds for all the major asset classes and most of their various subcategories. There’s also an expanding list of so-called alternative betas. Ours is a golden age for low-cost beta products and it allows the average investor to focus on the critical investing issue: designing and managing a portfolio of betas, a.k.a., asset allocation. You can, in short, engineer a rainbow of risk levels using a mix of betas, and at a very low cost.
Successfully managing asset allocation over time isn’t easy, but there are some simple things we can do to juice return while keeping a lid on risk. A rules-based rebalancing strategy, for instance, can help. Yes, there’s a lot more we can do, but we should be cautious in attempting to do too much. After all, few of us have the smarts of Warren Buffett.
Update: In the original version of this post, we erroneously used the term “seven-tenths of one percent” when we should have written “seven-hundredths of one percent.” The text has since been corrected above and the revised sentence now reads: “VTI, for instance, charges a mere 7 basis points, or seven-hundredths of one percent.” Sorry for any confusion.