Buffett's top recommendation has a better-than-expected return than any single stock, in his opinion.
Warren Buffett has built a reputation as one of the greatest investors of all time, and rightfully so. His track record as chairman and CEO of Berkshire Hathaway (BRK.A -0.56%) (BRK.B 0.07%), where he manages a $373 billion portfolio along with several wholly owned companies, is astonishing. And much of that portfolio's value was built on the back of great long-term stock investments.
There are two holdings in Berkshire's portfolio of 51 stocks that Buffett regularly and publicly recommends for most investors. And his recommendation hasn't changed for years. He thinks it's the best choice for almost everyone. He owns a small bit of each in his portfolio for Berkshire, too.
The two investments held in Berkshire Hathaway's portfolio that Buffett recommends more than anything else are two . The SPDR S&P 500 ETF Trust (SPY 1.24%) and the Vanguard S&P 500 ETF (VOO 1.24%).
Image source: The Motley Fool.
The best possible choice, on average
Buffett's recommendation to invest in an index fund instead of individual companies is quite a paradox.
Buffett made his fortune by buying individual stocks. Berkshire Hathaway holds a massive portfolio of individual companies. And the company has gone from a textile business to an insurance business to a diversified conglomerate holding everything from a candy company to a railroad under Buffett's leadership.
So, why does Buffett only recommend index funds? Because it's the best possible choice, "on an expectancy basis," as he put it.
In other words, buying an index fund has a higher expected return than buying any single individual stock or actively managed mutual fund. He said that makes an S&P 500 index fund like the SPDR S&P 500 ETF Trust or the Vanguard S&P 500 ETF "clearly the best choice," in his 2016 letter to Berkshire Hathaway shareholders.
Buffett put it this way at the 2020 Berkshire Hathaway shareholder meeting:
"You get surprises in this world and there will be businesses that we think are very good that turn out not to be not so good and there will be businesses that turn out better than we think."
That sentiment even applies to investing in Berkshire Hathaway.
"I recommend the S&P 500 to people, and I happen to believe that Berkshire is about as solid as any single investment can be in terms of earning reasonable returns over time, but I would not want to bet my life on whether we beat the S&P 500 over the next 10 years."
So, if Buffett had to recommend one investment to someone, it would be an S&P 500 index fund because investors can expect it to perform better than any single stock.
The easiest and cheapest path to diversification
Underlying Buffett's recommendation for an S&P 500 index fund is the need for diversification. It's seen right there in his statement during the 2020 shareholder meeting -- some businesses will outperform expectations and some will underperform expectations. And when performance doesn't match expectations, you get a stock price performance that deviates from the average.
Buffett not only sees index funds as the simplest path to achieve a diversified portfolio, but they're also the cheapest. One of the biggest factors that drives down the performance of mutual funds are the fees investors have to pay. That's led 92% of active mutual funds to underperform the market over the long run.
Both the SPDR S&P 500 ETF Trust and the Vanguard S&P 500 ETF charge low expense ratios. The former charges 0.09% while the latter charges just 0.03%.
Both are great options. Both have excellent track records for tracking the index and have plenty of liquidity. But if I had to pick one, I'd choose the Vanguard fund purely based on cost savings.
You might be able to outperform the market by carefully selecting individual stocks and building a diversified portfolio yourself. But an index fund is the simplest and easiest way to do it while offering an expected return that's just as good, if not better.
Adam Levy has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Berkshire Hathaway and Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.
