Warren Buffett Reveals the ‘Terrible Mistake’ Investors Keep Making—and Why It Matters

​The legendary investor Warren Buffett has repeatedly denounced 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 should make it impossible to consistently beat the market. Pointing to his own success, Buffett instead argues that savvy investors can achieve superior results through meticulous analysis and disciplined investing strategies.

Still, Buffett has long promoted the view that retail investors should mostly use index funds, which seems to conflict with his critiques of the EMH since that passive strategy tends to align with EMH principles. We take you through how he resolves this seeming contradiction below.

What Are ‘Efficient’ Markets?

The EMH describes financial markets as “informationally efficient,” where asset prices incorporate all available information instantly. The EMH suggests that trying to time the market can’t consistently generate better returns than the broader market (especially after fees and taxes) because any information affecting a company’s value would already be reflected in its stock price.

It’s no coincidence that passive index funds got their start in the 1970s, not long after major discussions about the EMH by economists. These funds focus on replicating market returns instead of outperforming them overall.

Buffett’s Contrarian View

Buffett has said that while the market is “generally fairly efficient,” he doesn’t think that supports an EMH strategy in investing, arguing that taking that approach would be a “terrible, terrible mistake.” Instead, he has said that investing is about valuing businesses.

“It’s crucial to understand that stocks often trade at truly foolish prices, both high and low. ‘Efficient’ markets exist only in textbooks,” Buffett wrote to stockholders in 2022. To bolster his case, Buffett has pointed to successful value investors, including his mentor Benjamin Graham, who consistently outperformed the market by identifying and buying undervalued stocks. 

More to the point, Buffett’s own impressive results suggest he’s right to doubt market efficiency. His management of Berkshire Hathaway Inc.’s (BRK.A, BRK.B) portfolio has resulted in returns that far exceed market averages across lengthy spans, which he says proves that dedicated analysis and disciplined investment practices can yield better performance.

Buffett’s Advice for Average Investors

Still, Buffett argues that despite his investment success and critique of EMH, most individual investors should choose low-cost index funds, including a sizable allocation to an S&P 500 index fund.

Although the advice appears in conflict, it just means different investors should have different strategies that fit their goals, lifestyle, and risk tolerance. Buffett recognizes that active value investing can beat the market, but doing so takes time, expertise, and strong emotional control that most investors don’t have. 

So, instead of trying to time the market, he advises buying index funds by putting a set amount aside, regardless of market conditions. Known as dollar-cost averaging, this strategy removes emotion from the equation and ensures investors always have a stake in the gains from the market’s long-term growth.

“The goal of the non-professional should not be to pick winners,” Buffett wrote in a letter to shareholders in 2013. Instead, they should “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.”

The Bottom Line

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