Warren Buffett warns of a ‘huge mistake’ most investors make – are you guilty of this?

Legendary investor Warren Buffett has repeatedly condemned the efficient market hypothesis (EMH), which claims that stock prices reflect all relevant information and always trade at their fair value. Beyond simple luck, this would make it impossible to beat the market consistently. Pointing to his own success, Buffett instead argues that smart investors can achieve superior results through careful analysis and disciplined investment strategies.

However, Buffett has long promoted the view that individual investors should mostly use index funds, which seems to conflict with his criticism of emerging market markets because that passive strategy tends to be consistent with emerging market principles. We take you through how to resolve this apparent contradiction below.

What are “efficient” markets?

The EMH describes financial markets as “information efficient,” where asset prices incorporate all immediately available information. EMH suggests that trying to time the market cannot consistently generate better returns than the broader market (particularly after fees and taxes) because any information that affects a company’s value will already be reflected in its share price.

It is no coincidence that passive index funds got their start in the 1970s, shortly after major discussions about how markets were run by economists. These funds focus on replicating rather than beating market returns overall.

Buffett’s contrarian view

Buffett said that although the market is “generally fairly efficient,” he doesn’t think that supports MMA’s investing strategy, arguing that taking that approach would be a “terrible, terrible mistake.” Instead, he said, investing is about valuing companies.

“It’s important to understand that stocks often trade at really foolish prices, whether high or low,” Buffett wrote to shareholders in 2022. “‘Efficient’ markets are only in textbooks.” To strengthen his case, Buffett pointed to successful value investors, including his mentor Benjamin Graham, who consistently outperformed the market by identifying and buying undervalued stocks.

More importantly, Buffett’s impressive results indicate that he is right to doubt the efficiency of the market. His management of Berkshire Hathaway Inc.’s portfolio led to (BRK.A) has achieved returns that far exceed market averages over long periods, which, he says, proves that personalized analysis and disciplined investment practices can lead to better performance.

Buffett’s advice for ordinary investors

However, Buffett says that despite his investing success and criticism of the asset management market, most individual investors should choose low-cost index funds, including a large allocation to a Standard & Poor’s 500 index fund.

Although the advice sounds conflicting, it means that different investors should have different strategies that suit their goals, lifestyle, and risk tolerance. Buffett realizes that active value investing can outperform the market, but doing so takes time, experience, and strong emotional control that most investors don’t have.

So, instead of trying to time the market, he recommends buying index funds by setting aside a specific amount, regardless of market conditions. This strategy, known as dollar-cost averaging, removes emotion from the equation and ensures that investors always have a share in the gains from long-term market growth.

“The goal of nonprofessionals should not be to pick winners,” Buffett wrote in a letter to shareholders in 2013. Instead, they should “own a broad cross-section of companies that are bound to perform well in aggregate. A low-cost S&P 500 index fund will achieve this goal.”

Bottom line

Although Buffett argues against the idea that markets determine the price of all available information — something that contradicts his approach to value investing — he supports investing in index funds for most people, given the real difficulties of consistently beating the market’s performance.