Warren Buffett is probably the world’s most famous investor, and he frequently touts the benefits of investing in low-cost index funds. In fact, he’s instructed the trustee of his estate to invest in index funds.
“My advice to the trustee couldn't be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund,” he noted in Berkshire Hathaway’s 2013 annual letter to shareholders.
Yet, despite Buffett’s advice, the wealthy typically don’t invest in simple, low fee, market-matching index funds. Instead, they invest in individual businesses, art, real estate, hedge funds, and other types of investments with high entrance costs. These risky investments generally require large buy-in costs and carry high fees, while promising the opportunity for outsized rewards.
- Wealthy investors can afford investments that average investors can’t.
- These investments offer higher returns than indexes do because there is more risk involved.
- Wealthy investors can absorb the high risk that comes with high returns.
How the Wealthy Invest
As an example, let's consider Steve Ballmer, the former CEO of Microsoft who reports a net worth of around $70 billion. Despite leaving Microsoft, he owns over 300 million shares in the company, a multi-billion-dollar investment.
Some of the other ways Ballmer chose to invest his money included a roughly 4% stake in Twitter (before he sold his shares in 2018), plus real estate investments in Hunts Point, Washington, and Whidbey Island. He bought the LA Clippers basketball team for $2 billion. His wealth is concentrated in a handful of investments—a far cry from the hundreds of investments that come with Buffett's (and many personal finance experts') suggestion of buying low fee index funds.
Hedge funds are likewise popular with the wealthy. These funds of the rich require investors to demonstrate $1 million or more in net worth and use sophisticated strategies intended to beat the market. But hedge funds usually charge approximately 2% of fees and 20% of profits. Investors need to get huge returns to support those high fees!
This isn't to suggest that the wealthy don't own traditional stocks, bonds, and fund investments—they do. Yet, their riches and interests open doors to other types of exciting and exclusive investments that aren’t typically available to the average person.
Why Don’t the Wealthy Invest in Low-Fee Index Funds?
Over the past 90 years, the S&P 500 averaged around a 9.5% annualized return. You’d think the rich would be satisfied with that type of return on their investments. For example, $10,038.47 invested in the S&P 500 in 1955 was worth $3,286,458.70 at the end of 2016. Investing in the whole market with index funds offers consistent returns while minimizing the risks associated with individual stocks and other investments.
But the wealthy can afford to take some risks in the service of multiplying their millions (or billions). For another example, look at world-famous investor and speculator George Soros. He once made $1.5 billion in one month by betting that the British pound and several other European currencies were overvalued against the German Deutsche Mark.
Hedge funds aim for those sorts of extraordinary gains, although history is filled with examples of years when many hedge funds failed to outperform the stock market indices. But they can also pay off in a big way for their rich clients. That's why the wealthy are willing to risk hefty buy-in fees of $100,000 to $25 million for the opportunity to reap great returns.
The one percent’s investing habits also tend to reflect their interests. As most wealthy people earned their millions (or billions) from business, they see this path as a way to continue maximizing their finances while sticking to what they know best—corporate structure and market performance. They also enjoy art, cars, homes, and collectibles. By buying those luxuries, the wealthy enhance their lifestyles, and they enjoy the value appreciation of those luxuries as a nice bonus.
The Bottom Line
The wealthy have massive incomes, net worths, and opportunities. Although they seek out unique investments in hopes of seeing spectacular returns, not all their ventures pay off with returns greater than a low-fee index fund. However, since they have more than enough cash on hand to survive, they're less dependent on steady returns. A simple investment strategy in low-fee index funds is good enough for Warren Buffett, and it’s good enough for the average investor.
Frequently Asked Questions (FAQs)
How do index funds work?
Index funds are generally set up to track the market performance of whatever particular index they follow (the S&P 500, for instance). Investors in an index fund should expect similar returns to the index itself, making it a fairly reliable, low-risk investment. They're usually passively managed, meaning managers aren't actively buying and selling much in order to keep fees low.
How much do index funds return?
The return rate on an index fund depends on the index it's modeled after. An S&P 500 index fund will generate different returns than a real estate market index fund, for instance.
What are the downsides of index funds?
Although index funds are generally a reliable way to invest, no investment is free of risk. Some index funds may underperform the market they're indexing, and some may be too rigid for an investor who wants flexibility and the opportunity to adjust as the market changes. Generally, passively managed funds offer less opportunity for outsized returns, as well.