What’s the best financial investment in the world?
If anyone knows the answer, it’s Warren Buffett. Buffett is the world’s richest investor and one of the world’s richest people. He’s worth tens of billions of dollars, accumulated over decades of savvy investments. And Warren Buffett’s advice? It’s in a letter he wrote to his wife, advising her how to invest after he dies. And it’s been published online for anyone to read.
Those instructions: Pick the most mediocre investment you can imagine. Put almost everything into “a very low-cost S&P 500 index fund.”1
Yes. An index fund. The idea of an index fund is to be mediocre by definition—to passively track the market as a whole by buying a little of everything, rather than to try to beat the market with clever stock picks—the kind of clever stock picks that Warren Buffett himself has been making for more than half a century.
Index funds now seem completely natural—part of the very language of investing. 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 named Charles Dow had the bright idea that he could 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.2
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 now talk about the stock market rising by 2.3 percent 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 the autumn of 1974, the world’s most famous economist took an interest. The economist’s name was Paul Samuelson. He had revolutionized the way economics was practiced and taught, making it more mathematical—more like engineering and less like a debating club. His book Economics was America’s best-selling textbook in any subject for almost thirty years. He advised President Kennedy. He won one of the first Nobel memorial prizes in economics.3
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 anymore.
That idea has become known as the efficient-markets hypothesis. It’s probably not quite true; investors aren’t perfectly rational, and some investors are more interested in covering their backsides than they are in taking well-judged risks. (Some fund managers stick with the herd, meaning that when things go wrong they have the excuse that everyone else made the same mistake.) But the efficient-markets hypothesis is mostly true. 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.
Samuelson laid out his thinking in an article titled “Challenge to Judgment,” which said that most professional investors should quit and do something useful instead, like plumbing.4 And Samuelson went further: he 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 performance of the stock market as a whole, without paying a fortune in fees for fancy professional fund managers to try, and fail, to be clever.
At this point, something interesting happened: a practical businessman actually paid attention to what an academic economist had written. John Bogle had just founded a company, Vanguard, whose mission was to provide simple mutual funds for ordinary investors—no fuss, no fancy stuff, low fees. And what could be simpler and cheaper than an index fund—as recommended by the world’s most respected economist? And so Bogle decided he was going to make Paul Samuelson’s wish come true. He set up the world’s first index fund and waited for investors to rush in.5
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 said it was 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 faith, and slowly people started to catch on. Active funds are expensive, after all; they often trade a lot, buying and selling stocks in search of bargains. They pay analysts handsomely to fly around meeting company directors. The annual fees might sound modest—just a percent or two—but they soon mount up: if you’re saving for retirement, a one percent annual fee could easily eat away a quarter or more of your retirement fund. Now, if the analysts consistently outperform the market, then even that sort of fee would be money well spent. But Samuelson showed that, in the long run, most don’t.
The super-cheap index funds looked, over time, to be a perfectly credible alternative to active funds—without all the costs. So slowly and surely, Bogle’s funds grew and spawned more and more imitators—each one passively tracking some broad financial benchmark or other, each one tapping into Paul Samuelson’s basic insight that if the market is working well you might as well sit back and go with the flow. Forty years after Bogle launched his index fund, fully 40 percent of U.S. stock market funds are passive trackers rather than active stock-pickers.6 You might say that the remaining 60 percent are clinging to hope over experience.
Index investing is a symbol of the power of economists to change the world that they study. When Paul Samuelson and his successors developed the idea of the efficient-markets hypothesis, they changed the way that markets themselves worked—for better or for worse. It wasn’t just the index fund. Other financial products such as derivatives really took off after economists figured out how to value them.7 Some scholars think the efficient-markets hypothesis itself played a part in the financial crisis, by encouraging something called “mark to market” accounting—where a bank’s accountants would figure out what its assets were worth by looking at their value on financial markets. There’s a risk that such accounting leads to self-reinforcing booms and busts, as everyone’s books suddenly and simultaneously look brilliant, or terrible, because financial markets have moved.8
Samuelson himself, understandably, thought that the index fund had changed the world for the better. It’s already saved ordinary investors literally hundreds of billions of dollars.9 That’s a big deal: for many, it’ll be the difference between scrimping and saving or relative comfort in old age. In a speech in 2005, when Samuelson himself was ninety years old, he gave Bogle the credit. He said, “I rank this Bogle invention along with the invention of the wheel, the alphabet, Gutenberg printing, and wine and cheese: a mutual fund that never made Bogle rich but elevated the long-term returns of the mutual-fund owners. Something new under the sun.”10