In 2007, Warren Buffett made a bold move. The legendary investor bet $1 million that a simple, no-nonsense S&P 500 index fund could beat a selection of carefully selected hedge funds over a ten-year period. Experts manage the hedge funds, and they charge a low fee for this. Many see them as the pinnacle of advanced investing.
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However, Buffett believed that something as simple as an index fund, which simply tracks the performance of the 500 largest companies in the US, would perform better in the long run.
What was the result? Buffett won the bet comfortably. Over the ten years, his selected Vanguard S&P 500 Index Fund delivered an astonishing 125.8% return, while hedge fund returns ranged from 2.8% to 87.7%. But how could this “ordinary” investment approach surpass some of the most talented financial minds?
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Warren Buffett has argued that low-cost index funds have been a sensible investment option for most people for years. An index fund allows investors to own a portion of each company in the index, rather than trying to time the market or identify the next big stock.
It is a hands-off strategy that merely replicates the overall performance of the market. As Buffett said, “You don’t have to, you just have to sit back and let American industry do its work for you.”
This may sound too simple to be effective, especially compared to the complex strategies used by hedge funds. However, Buffett has always said that keeping costs low is the key to successful investing. Hedge funds typically charge a lot of fees: about 2% of your money per year, plus 20% of any profits they make. These high costs can reduce your earnings over time.
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In contrast, the Vanguard fund that Buffett chose had an expense ratio of just 0.04%, meaning virtually all of the investment’s growth stayed in the investor’s pocket. “Costs matter in investing, there’s no doubt about that,” said Ted Seides, the hedge fund manager who accepted Buffett’s bet. He later admitted that Buffett was right about the impact of high fees.