﻿Mr. Warren Buffett is worth over $100 billion dollars today. And though it hurts me to say it,
he didn’t get there by investing in index funds. He’s made some incredible individual
stock purchases in his 7 decades of investing. Companies like Apple, American Express and Coca
Cola. So how shocking was it when in this 2013 letter to Berkshire Hathaway investors,
he noted that upon his death, the trustees of his wife’s inheritance were instructed to put 90%
of her money into a very low-fee stock index fund and 10% into short-term government bonds. A simple
2-fund portfolio. Now the question is, what was Warren Buffet thinking? And more importantly,
is this actually an effective strategy? But first, if you are new to the channel,
my name is Tae from Financial Tortoise. Where we learn how to build our wealth,
patiently and slowly. Consider subscribing if you’d like to build wealth together.
Let’s delve a bit deeper into this sensational letter. In the section Mr. Buffest lays out
the 2-fund portfolio, he starts out by saying how he and his business partner,
Charlie Munger made study of business prospects a priority in their lives. And he goes on to say to
the rest of us mortals, that if we were wise, we would conclude that we do not know enough about
specific businesses to predict future earnings. It’s a humbling message. But if a man worth $100
billion dollars is sharing his wisdom, I’m willing to listen. However, the next part of the letter
bears good news for commoners like me. He says that a typical investor like me doesn’t need the
stock picking skill like him. In aggregate, the American business has done wonderfully over time
and will continue to do so. In the 20th Century, the Dow Jones Industrial index
started out at $66 dollars and ended at $11,497. Warren Buffet believes the 21st century will
witness further substantial gains. Therefore, this is the important part. He goes onto say,
“The goal of the non-professional should not be to pick winners – neither he nor his “helpers” can do
that – but should rather be to own a cross-section of businesses that in aggregate are bound to do
well. A low-cost S&P 500 index fund will achieve this goal.” - Warren Buffet Warren Buffet then
goes on to recommend the two-fund portfolio. Not just for average individual investors like you
and I, but also in instruction to his trustee. 10% of the cash in short-term government bonds
and 90% in a very low cost S&P 500 index fund. I love how he specifically recommends Vanguard.
For the specific fund, this would translate to Vanguard’s S&P 500 Index Fund, the VFIAX
and the Vanguard Short-Term Treasury Index Fund, the VSBSX. And he ends this section by saying he
believes “the trust’s long-term results from this policy will be superior to those attained by most
investors – whether pension funds, institutions or individuals – who employ high-fee managers.”
Again, I want to emphasize the significance of this statement. Warren Buffet made his living by
picking stocks. Ones that made him a billionaire today. Yet, following his death, he recommends an
index fund strategy. And a simple 2-fund strategy at that. It almost feels like a man who made his
living racing horses his whole life saying to his kids, don’t worry about horses, you should get an
electric car instead. And Warren Buffet isn’t the only one that touts this simple 2-fund strategy.
JL Collins. One of my favorite authors who wrote the Simple Path to Wealth also recommends a simple
2-fund strategy. His recommendation is slightly different in the specific fund, but the general
concept is pretty much the same. He recommends a Total Market Index Fund. A Vanguard specific fund
would be Vanguard Total Stock Market Index Fund, the VTSAX. And for bonds, he recommends Vanguard
Total Bond Market Index Fund, VBTLX. And he breaks down his recommendation by phases in life.
When you are in your wealth accumulation phase, when you are still investing into the market,
he recommends 100% in stocks, VTSAX. He believes that you should be aggressive in your wealth
accumulation phase, and I personally agree. You have time on your side and because you are in the
accumulation phase, the market ups and downs don’t matter. And when you are in the wealth
preservation phase, when you are living off your investments, he allocated his funds to 75% stocks,
and rest in bonds and cash. So the question is this, is a two-fund portfolio a sound investment
approach? Is it something I could follow? And the simple answer is yes. Let me give you a few
reasons why this simple index fund investing strategy is so effective. Number one reason,
and Warren Buffet nailed this on the head, is that we can’t pick winning stocks. Warren
Buffet and Charlie Munger made a profession out of researching and identifying undervalued companies.
And to their own admittance, they’ve made mistakes as well. People forget that Warren Buffet lost
$3.5 billion dollars on Dexter Shoes - and he admits that it was the worst deal that he ever
made. But through these mistakes, Warren Buffet honed his stock picking skills. Over a period of 7
decades. And thus made himself a household name. I think we should check our ego if we think we
could pick stocks like Warren Buffett. The harsh truth is that I can’t pick winning individual
stocks or mutual funds and neither can you. Nor can the vast majority of people who claim they did
or can. If you happen to be one in a billion who can, I’m not sure why you are watching this video.
It is ridiculously difficult and having the humility to accept this will be the key to making
you rich and wealthy. Index investing is powerful because despite our lack of stock picking skills,
we can still amass quite a bit of wealth by harnessing the power of the equities market.
Another reason why a simple two-fund index fund strategy is so effective is that most people paid
to deliver higher returns than the stock market, such as financial advisors and fund managers,
as a whole can’t do it. When we talk about "the stock market" we are most often referring to
what is known as the Standard & Poor's 500, or simply the S&P 500. The S&P 500 is an index of
the 500 largest companies on the American stock market. It includes major companies such as Apple,
Google, Coca-Cola, McDonalds including hundreds of other large to small companies. Since 1980,
the S&P 500 has delivered an annual average of over 7% - so in order to beat the market,
a financial advisor would need to design a portfolio that surpasses this number.
This is not easy. The financial advisor must be skilled at designating the right investments,
diversifying and keeping up with market trends - a tall order for anyone. Very few financial advisors
have the skill and knowledge necessary to beat an index fund. According to a 2020 SPIVA report, over
a 15-year period, nearly 90% of actively managed investment funds failed to beat the market.
The majority of these actively managed funds had either poor performance and high fees or average
performance and low fees, but only about one out of every ten performed well on both fronts.
Another reason why Index investing is so effective is its low operating cost. Actively managed
funds are known to charge anywhere between 1 to 2 percent expense ratios. This means that between 1
to 2 percent of your investment is deducted each year to pay the fund manager to run the fund.
On a $100,000 portfolio, that comes out to $1K to $2K annually. By contrast, index funds are much
cheaper given no person is actually managing the fund’s performance. There isn’t a person
deciding which funds to buy or sell or when to buy or sell them. The fund simply replicates
the index. As a result, most index funds have an expense ratio well under 0.1%. VTSAX and VFIAX,
Vanguard’s Total Stock Market Index Fund and Vanguard's S&P 500 Index Fund have respective
expense ratios of 0.04%. On a $100,000 portfolio, this comes out to $40 annually. I’ll take a $40
expense over $2,000 any day. And the real power of low operating cost really comes to play when you
incorporate compounding into the formula. These expense ratios can net you or cost you hundreds
of thousands of dollars over a period of 10 to 20 years. Cost matters and the king of low cost
are passively managed index funds. So you might be saying at this point. Alright Tae. I got it.
Warren Buffet and JL Collins 2-Fund Index Fund portfolio strategy makes sense.
But how about compared to a 3-Fund Portfolio? Great question. The 3-Fund Portfolio is an
investing approach made widely popular by the Bogleheads. Devout followers of Mr. Jack
Bogle’s investing philosophy. And I’ve also talked extensively about its benefits here in this video.
Simply, a 3-fund portfolio is a portfolio made up of an equities index fund, international index
fund and a bond index fund. A popular Vanguard selection of these three funds are as follows:
Vanguard Total Stock Market Index Fund, VTSAX. You could also substitute it for an S&P 500 fund,
VFIAX. Vanguard Total International Stock Market Index Fund, VTIAX. Vanguard Total Bond Index Fund,
VBTLX. You could also substitute it for Vanguard Short-Term Treasury Index Fund, the VSBSX,
based on Warren Buffet’s recommendation. So when we compare this 3 fund portfolio
to the two fund portfolios, the glaring difference is the absence of an international stock fund.
So let’s talk a bit about this International Fund. I also have a specific video where I delve
deeper into VTIAX you can check out here, but in a nutshell VTIAX, Vanguard’s Total International
Stock Index Fund represents close to 8,000 non-US based companies. All international companies we
may have heard of such as Samsung, Shell and Alibaba are in it. And thousands of others we
may have never heard of. By having this fund in your portfolio, you get exposure to emerging and
developed market holdings, spread all around the world. Now, why would Warren Buffet and JL
Collins exclude this fund from their recommended portfolio? There are a few reasons. One due to
accounting risk. Accounting is not a sexy topic, but you have to give it to America’s accounting
standards. Compared to many other countries in the world, especially emerging countries,
America’s accounting practices are top notch. When American companies produce their quarterly
and annual financial reports, they need to adhere to strict accounting policies. Many
other countries do not have the same level of transparent and strict accounting standards
that’s required here in the US. So what this means is that when we review a foreign company’s
latest annual financial report, there is a chance that the numbers reported are not as
accurate because they did not have to adhere to strict American accounting standards. Another
reason for excluding international funds is that the world economy is a lot more integrated today
than ever before. Many of the major US based companies today aren’t just domestic companies,
but they are actually international corporations. They generate a good percentage of their sales
and profit overseas. For example, just look at Apple. The biggest US company based on
market capitalization. As of the second quarter of fiscal year 2021, 67% of Apple’s total revenue was
generated from outside the United States. At one point, there were more Chinese people purchasing
Apple products than there were Americans. So the perspective Warren Buffet and JL Collins
could have is that when you hold US based company stocks, you already have access to the growth of
the world market and are able to gain the benefit of that growth. And a final reason for excluding
international funds could be due to its lackluster performance the past decade. When we compare VTSAX
vs. VTIAX the past 10 years. From 2012 to present, the 10-year return on international funds is
pretty dismal compared to the US market. 4.5% vs. 11.8%. But this doesn’t mean international funds
always performed poorly. When we compare general domestic vs. international index fund returns
the prior decade from 2000 to 2009 from this chart I borrowed from the Bogleheads Guide to Investing,
we see that the international market outperformed the domestic market 7 out of 8 years. Sometimes
in margins of double digits. In this scenario, the 3-fund portfolio, which would have included
international funds, would have done much better. So what does this mean when we compare 2-fund
vs. 3-fund portfolio? The real key difference between these two funds is really the presence
of international funds. And international funds did really well in the 2000s whereas in the 2010s
it underperformed against the domestic market. And this is the part where I include the most
common investment disclaimer known to mankind. “Past performance is not indicative of future
performance.” What would the international market do in the next 10, 20, 30 years?
But the more important question is should you include them in your portfolio? I never like it
when people tell me this, but it really depends. So much of it depends on your worldview and
appetite for risk for the international market. If you believe that in today’s global economy US
companies are no longer exclusively US companies and that they are international corporations,
a 2 fund portfolio might make sense for you. There is good evidence to reinforce this assumption.
Just look back to the recession of 2008. It’s most often referred to as the “Global Financial
Crisis.” Not just a US crisis. What happened with the US housing market had a ripple effect
across the globe because our markets and companies are all now so tightly integrated.
Growth in countries like China and South Korea is already being reflected in US companies like Apple
who are selling their latest iPhones overseas. And another reason why a 2-fund portfolio might make
sense for you is if you just want simplicity. 2 is always easier to manage than 3 and if you want
that level of simplicity in your life, I believe the 2-fund portfolio would be perfect for you.
Alright, so where do I personally stand? Somewhere in between. I love the simplicity of the 2-fund
portfolio, but I also like the idea of having some limited international exposure. So the majority
of my equities are held in VTSAX. And I have a small percentage in VTIAX. Really small percentage
until I get more comfortable with international exposure. And I’m adding a little bit of VBTLX
as I get closer to my retirement age. If you want to delve deeper into the 3-fund portfolio,
check out my video here. Thank you guys for watching and until next time, all the best.