Key Points
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Although he compounded Berkshire Hathaway’s stock at nearly 20% annually for six decades, Buffett is a huge fan of the Vanguard S&P 500 ETF.
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The stock market’s current valuation and AI’s uncertain impact on the economy are on every investor’s mind.
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A return to the market’s roughly 10% historical average is likely the most probable outcome.
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The data makes the case that Warren Buffett is the best investor who ever lived. For six decades, he directed capital allocation decisions that compounded Berkshire Hathaway‘s stock price at a rate of nearly 20% per year. That’s almost double what the S&P 500 index (SNPINDEX: ^GSPC) returned during that time.
A sharp analytical mind, calm nerves, and a long-term time horizon are all favorable attributes that the Oracle of Omaha possesses. Every investor wants to develop these traits.
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But what’s interesting is that Warren Buffett has an extremely simple suggestion for the average person looking to build wealth. He doesn’t recommend picking individual stocks. Instead, he advocates for owning an S&P 500 index fund, such as the Vanguard S&P 500 ETF (NYSEMKT: VOO). Maybe investors should listen to this advice.
Here’s what $500 a month allocated to this exchange-traded fund would be worth in 20 years under three different return scenarios.
At 5% annualized
The first scenario assumes the market’s performance will be significantly below its long-term average. Historically, the S&P 500 index has generated an annualized total return of approximately 10%. If that were cut in half annually, investors would certainly be disappointed.
There are definitely bears out there who believe this will happen. They might even predict worse returns going forward.
Valuation is unquestionably the biggest concern for investors right now. The cyclically adjusted price-to-earnings (CAPE) ratio, a valuation metric that uses 10 years’ worth of inflation-adjusted earnings to smooth out short-term ups and downs, is around historic highs at 40.6. Buffett’s namesake indicator, which compares the total market capitalization of U.S. stocks to gross domestic product (GDP), is sitting around 234%, well into the valuation danger zone. And because the S&P 500 is weighted by market cap, its results are currently tied to a handful of companies that are much bigger than the rest.
If you invest $500 a month for 20 years at a 5% annualized rate of return, you’d have $205,000 in 20 years. This isn’t exactly a compelling proposition. Investors can buy a 10-year U.S. Treasury note that offers a 5% risk-free yield at recent prices.
At 10% annualized
The next possible scenario simply expects the S&P 500 to match its historical performance. The drivers would resemble past catalysts, including earnings growth and dividends. Valuation expansion, or at least avoiding contraction, will also play a role.
The economy, of course, must also be healthy. Over the past 20 years, U.S. GDP has grown at an annualized rate of 4.4% in nominal terms. That trend likely needs to continue. Inflation, which is the Federal Reserve’s key focus, must be kept under control.
If you invest $500 a month for 20 years at a 10% annualized rate of return, you’d have $364,000 in 20 years. This seems to be the most likely outcome, given that it assumes the market reverts to the mean. That’s probably the forecast used by most investors, myself included.
At 15% annualized
Over the past decade, the S&P 500 index produced a total return of 322%. On an annualized basis, this is an exceptional 15%. My most bullish scenario expects the benchmark to keep up this above-average pace far into the future.
This situation completely disregards any worries about valuation. While the market’s valuation is historically elevated, it doesn’t guarantee poor performance going forward. Investors should understand that they can still make money in the long run. And unsustainable things can go on for a very long time.
The CAPE ratio expanded by 51% in the last 20 years. This could happen again, giving stocks a powerful tailwind.
There is also optimism around improving capabilities and broad adoption of artificial intelligence and what it could do for the economy. The bulls believe it will lead to explosive growth that the world hasn’t seen before.
If you invest $500 a month for 20 years at a 15% annualized rate of return, you’d have $669,000 in 20 years.
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Neil Patel has positions in Vanguard S&P 500 ETF. The Motley Fool has positions in and recommends Berkshire Hathaway and Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.
