18/07/17

Why the world's biggest investor backs the simplest investment

What's the best financial investment? If anyone knows, it's Warren Buffett, the world's richest investor, writes Tim Harford for the BBC.

He's worth tens of billions of dollars, accumulated over decades of savvy investments. His advice is in a letter he wrote to his wife, advising her how to invest after his death, which anyone can read [page 20, paragraph 6].

Those instructions: pick the most mediocre investment you can imagine. Put almost everything into "a very low-cost S&P 500 index fund".

An index fund is mediocre by definition. It passively tracks the stock market as a whole by buying a little of everything, rather than trying to beat the market by investing in individual companies - as Warren Buffett has done so successfully for more than half a century.

Bright idea

Index funds now seem completely natural. But as recently as 1976, they didn't exist.

Before you can have an index fund, you need an index.

In 1884, a financial journalist called Charles Dow had the bright idea to take the price of some famous company stocks and average them, then publish the average going up and down.

He ended up founding not only the Dow Jones company, but also the Wall Street Journal.

The Dow Jones Industrial Average didn't pretend to do anything much except track how shares were doing, as a whole.

But thanks to Charles Dow, pundits could talk about the stock market rising by 2.3% or falling by 114 points.

More sophisticated indices followed - the Nikkei, the Hang Seng, the Nasdaq, the FTSE, and most famously the S&P 500. They quickly became the meat and drink of business reporting all around the world.

Then, in 1974, the world's most famous economist took an interest.

Paul Samuelson had revolutionised the way economics was practised and taught, making it more mathematical and engineering-like, and less like a debating club.

His book Economics was America's bestselling textbook in any subject for almost 30 years. He won one of the first Nobel memorial prizes in economics.

Efficient markets

Samuelson had already proved the most important idea in financial economics: that if investors were thinking rationally about the future, the price of assets such as shares and bonds should fluctuate randomly.

That seems paradoxical, but the intuition is that all the predictable movements have already happened: lots of people will buy a share that's obviously a bargain, and then the price will rise and it won't be an obvious bargain any more.

His idea became known as the efficient markets hypothesis.

It's probably not quite true. Investors aren't perfectly rational, and some are more interested in covering their backsides than taking well judged risks. But the hypothesis is true-ish. And the truer it is, the harder it's going to be for anyone to beat the stock market.

Samuelson looked at the data and found - embarrassingly for the investment industry - that, indeed, in the long run, most professional investors didn't beat the market.

And while some did, good performance often didn't last. There's a lot of luck involved, and it's hard to distinguish that luck from skill.

In his essay Challenge To Judgment Samuelson argued that most professional investors should quit and do something useful instead, such as plumbing.

He also said that, since professional investors didn't seem to be able to beat the market, somebody should set up an index fund - a way for ordinary people to invest in the stock market as a whole, without paying a fortune in fees for fancy professional fund managers to try, and fail, to be clever.

Then, something interesting happened: a practical businessman paid attention to an academic economist's suggestion.

John Bogle had just founded a company called Vanguard, whose mission was to provide simple mutual funds for ordinary investors, with no fancy stuff and low fees.

'Bogle's Folly'

And what could be simpler and cheaper than an index fund - as recommended by the world's most respected economist?

So Bogle set up the world's first index fund, and waited for investors to rush in.

They didn't. When Bogle launched the First Index Investment Trust, in August 1976, it flopped.

Investors weren't interested in a fund that was guaranteed to be mediocre. Financial professionals hated the idea - some even called it "un-American".

It was certainly a slap in their faces. Bogle was effectively saying: "Don't pay these guys to pick stocks, because they can't do better than random chance. Neither can I, but at least I charge less." People called Vanguard's index fund "Bogle's Folly".

But Bogle kept the faith, and slowly people started to catch on.