Index Funds

If you have $1,000,000 and plan to retire early on it, how much can you actually spend each year? Spend too much and you risk running out of money before you run out of time. Spend too little and you shortchange yourself for decades. Is there a withdrawal rate that is safe enough to last forever? There is. It is called the 4% rule. What the rule says Assume inflation runs at 2%. If your portfolio compounds at 6% a year, you can withdraw 4% of it every year without your capital shrinking. ...

If you earn 10% a year, what is your total return after ten years? Most people answer 100%. That answer is wrong, because it ignores compounding. The correct answer is 159%. The mechanism is simple. The first year’s gain takes part in the second year’s growth, and the second year’s gain produces gains of its own. The longer the horizon, the more dramatic the effect. Einstein is said to have called compound interest the eighth wonder of the world: those who understand it earn it, and those who do not pay it. So how do ordinary investors put it to work? Two things matter. ...

The bar for financial freedom may be much lower than you think. Take an ordinary person who spends $60,000 a year. By the 4% rule, they need $1.5 million to be financially free. Spend $100,000 a year and the number is $2.5 million. The next question is usually: how on earth do I accumulate that? Buffett’s answer is straightforward — invest regularly and for the long term in low-cost index funds, which have compounded at roughly 7% a year. Subtract 3% inflation and you keep about 4% in real terms. ...

By investing regularly in an index fund, an investor who knows nothing can outperform most professionals. When dumb money admits it is dumb, it stops being dumb. For most investors, institutional or individual, the best way to own stocks is to hold a lowest-cost index fund. Those who follow that path will, after fees and costs, end up ahead of the vast majority of professionals. Very low-cost index funds are extraordinarily friendly to investors. For most people, they are the best choice there is.

Charlie Munger says an amateur investor only needs to ask two questions to decide whether index funds are right for them. First: how good am I as an investor? Is my own ability above the market average? Second: can I find an excellent fund manager? And are the managers I pick actually able to beat the market? Answer those two questions honestly, and you will know whether — as an amateur investor — you should be buying index funds. ...