Index Funds are also the very first of the investment strategies recommended by Buffett's mentor, Benjamin Graham.
Buffett Writes
Warren Buffett — generally considered one of the world's best investors — has often suggested that investors use Index Funds. In his 2016 annual letter to shareholders, the famous Chairman of Berkshire Hathaway Inc again wrote:
"When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds."
"My regular recommendation has been a low-cost S&P 500 index fund. To their credit, my friends who possess only modest means have usually followed my suggestion."
Warren Buffett, Berkshire Hathaway: Letter to Shareholders (2016).
Benjamin Graham
Index Funds are also the very first of the investment strategies recommended by Buffett's mentor — Benjamin Graham — and for much the same reasons.
Returns ∝ Intelligent Effort
Contrary to popular belief that greater profits require greater risks, Graham said that profits depended on the intelligence and effort that went into one's portfolio; not the risk.
Graham was perhaps the first to point out that risk was something to be avoided in investments, and not something to be pursued; a fact that his student Warren Buffett and other Value Investors such as Seth Klarman continue to emphasize on.
1. Minimum Intelligent Effort: Index Funds
Graham taught that the easiest strategy — for any investor who did not have the time for stock research — was to invest in stocks comprising an index.
Since they did not have Index Funds in Graham's day, it should be safe to say that Graham's first recommended strategy today would have been to invest in a reputed Index Fund.
So when Warren Buffett recommends a low-cost S&P500 tracking index fund today, he is simply outlining another application of Benjamin Graham's Value Investing principles. Graham even pointed out that the S&P500 tends to outperform the Dow.
2. Intermediate: Defensive, Enterprising & NCAV
For investors who were willing to put in the time and effort required for careful stock selection, Graham recommended three categories of stocks — Defensive, Enterprising, and NCAV.
He also specified seventeen rules to identify such stocks; based on qualitative factors such as growth and stability, as well as quantitative factors such as earnings and assets.
3. Maximum Intelligent Effort: Special Situations
These include acquisitions of smaller firms by larger ones, arbitrage operations, the breakup of public-utility holding companies due to legislation, issues that are involved in any sort of complicated legal proceedings etc.
But being able to identify and take advantage of a special situation requires years — even decades — of experience with Graham's primary investment strategies.
Investing in Index Funds therefore is very much part of Graham's framework.