Insights · Letter No. 2 · Strategy
Index funds or stock picking? What the evidence says
Owning the whole market sounds unambitious. Decades of data suggest it is one of the hardest strategies to beat.
An index fund does not try to find the best companies. It simply owns all of the companies in an index, such as the S&P 500 or a total-market index, in proportion to their size. A stock picker, or an actively managed fund, tries to own only the winners. The question is which approach leaves the typical investor with more money after costs.
The arithmetic
Before costs, the average dollar invested in a market earns the market's return, because all investors together are the market. After costs, the average actively managed dollar must therefore trail the average passive dollar by roughly the difference in fees and trading costs. Economist William Sharpe called this "the arithmetic of active management." It does not say no one can win; it says the average participant cannot.
The scorecard
S&P Dow Jones Indices publishes the SPIVA scorecard twice a year, comparing actively managed funds with their benchmarks. In report after report, the majority of U.S. large-cap active funds trail the S&P 500 over 10- and 15-year periods; over the longest windows the share is commonly around nine in ten. Results vary by category and year, so check the latest edition, but the long-run pattern has been remarkably consistent.
Costs compound too
A fee looks small as a percentage. Over decades it is not. On a $100,000 portfolio growing 7% a year for 30 years, the difference between a 0.05% and a 1.00% annual fee is roughly $176,000 of ending wealth (about $751,000 versus $574,000). You can test your own numbers in our compound growth calculator.
When picking stocks can make sense
- You genuinely enjoy the research and treat it as a craft, not a lottery.
- You keep the bulk of your savings diversified and use only a portion you can afford to see underperform.
- You measure yourself honestly against a simple index over many years, including every cost and tax.
Questions to ask about any fund
- What is the expense ratio, and what am I getting for it?
- Which index or benchmark does it track or compete with?
- How broad is it? A fund of 500 or 3,000 companies diversifies very differently from a narrow sector fund.
- How tax-efficient is it if held in a taxable account?
Index investing is not exciting, and that is part of its strength. It removes the need to be right about which company wins, and leaves you to focus on the things you can control: how much you save, what you pay, and how patiently you hold.
This letter is general education, not a recommendation to buy or sell any security. Consider your own situation, and a licensed professional, before making financial decisions.