How hard is it to beat an index?

Pretty hard, as it turns out.  Take, for instance, the S&P 500, the bellwether large cap index. The index produced a 5 percent annualized return over the last 15 years. How many of its 500 component stocks beat the index over that timeframe? The number and names may surprise you.

Place your bet, take your chance

If you guessed 250 of the 500 stocks beat the index, you are not alone. And you are not correct.

It almost sounds like a trick question – about half should beat the index in the long run while the other half come up short. Well, that sounds logical, but because the index is weighted by capitalization, larger stocks carry more weight and significantly skew the results. Here are the facts:

• Half of the companies are no longer in the index (they were acquired, went out of business or were dropped from the index)
• Of the remaining half, only 28 percent of the stocks met or exceeded the 5 percent annual index return
• Only 40 percent of the companies had positive returns

I think this data would surprise many practicing stock-pickers, and hope it would dissuade anyone from taking up the craft. These just do not look like good odds to me if I am attempting to build an investment portfolio to reach my goals. Picking stocks at random clearly puts you at a disadvantage, and given the many factors that influence stock performance, I feel that just about any stock pick is in truth random.

Ten surprises

If the numbers don’t make the point strongly enough, look at the names. These are the top 10 performers (total annualized return) from the index over the last 15 years:

This list amazes me. Sure, we all knew with certainty in 1997 that Apple, then a $5 stock with no leading products, was headed for $500 plus. Such a no-brainer. But the rest of the top ten looks like a random drawing from every sector of the economy – from clothing and energy companies to auto parts, food packaging, and engines, to the maker of Botox.

I would love to attend a stock-picking seminar that teaches how to pick ten companies with so little in common that would lead the S&P 500 for 15 years.

No racing, betting, or guessing

At Osbon Capital, our approach is the opposite of stock-picking. We index. We don’t race (“Beat the S&P 500!”), bet (“I think it’s going up”), or guess (“Our estimate is….”).

With indexing you get the approximate index return for that asset class.  For example, by owning DIA, the 30 stock ETF that replicates the Dow Jones Industrial average, you will get a return very close to that of Dow, minus the 7 basis point expense ratio.  Over the last 40 years, as we noted in Dividends on Dividends, the Dow’s return has been 10% annualized.

You can think of a well-constructed index as a survival of the fittest fund. Winning companies become a larger share of the index. Losing companies shrink or get dropped from the index, replaced by growing companies. Companies that are acquired or go out of business are efficiently replaced with no decision making required by the investor.

Half the companies in the S&P 500 have turned over in the last 15 years. As an aside, all that turnover has not meant a big tax tab for owners of SPY (the S&P 500 index ETF). In fact, SPY has never had a declared a taxable gain since inception in 1993.

Ask yourself

The next time you are considering buying an individual stock – any stock – think about the S&P 500 data above and ask yourself:

• Am I investing, or speculating?
• How much better than the index do I expect to do?
• What is my cost of being wrong?

Or, you can avoid those nagging questions…and index!

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This article may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.

Nothing in this article is intended to be or should be construed as individualized investment advice. All content is of a general nature. Individual investors should consult their investment adviser, accountant, and/or attorney for specifically tailored advice.

Any references to third-party data or opinions are listed for informational purposes only and have not been verified for accuracy by the Adviser. Adviser does not endorse the statements, services or performance of any third-party vendor without specifically assessing the suitability of a third-party to a client’s or a prospective client’s needs and objectives.

All data from Bloomberg. Annualized returns are rounded to nearest whole number. 15 year index return is for period ending May 20, 2012.