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Sound Advice: March 20, 2024

Here’s Why No One Beats The Market Index

In Las Vegas, the house always wins.  And on Wall Street, the market always wins. Let me explain.

Although the media tends to focus on the Dow Jones Industrial Average, which includes only 30 of the largest companies, professional investors compare their results with the Standard & Poor’s 500 Index, a far broader contingent.

But there’s a hitch.  The hitch is that the impact of the company shares included in the index is determined by their overall value.  So it turns out that the top five companies (Apple, Alphabet, Google, Microsoft, and Nvidia) represent more than 21% of the value of the S&P 500.  The movements of these five stocks largely determine the overall movement of the index.

Over time, other mega cap stocks with strong performances may become increasingly important as their market capitalization (number of shares times the stock price) grows.  That provides an ongoing infusion of new market strength.  The only way professional money managers can keep up with the S&P is to follow the same replacement cycle.  With the S&P, it’s automatic.

Let’s not forget that actively managed funds have higher fees and trading costs compared to passively managed indexed funds.  Over time, these costs can eat into returns and make it harder for actively managed funds to outperform their benchmark.

Some managers may outperform the market for short periods, but maintaining that level of outperformance over the long term is challenging.  Strategies that have worked well in the past rarely have staying power.

And then there’s the matter of herd behavior, where fund managers may be reluctant to deviate significantly from the benchmark, limiting their ability to make contrarian or unconventional investment decisions.

It gets worse.  Professionals may face pressure to deliver short-term results, which can lead to a focus on quarterly or annual performance rather than a long-term investment horizon.  This short-term focus may hinder their ability to make patient, value-driven investment decisions.

Some active managers do outperform the market over certain periods, but consistently beating the market over the long term is a formidable challenge, one that invariably proves fruitless.

Why try to beat the house when you can be the house by choosing low-cost index funds that passively track the market index.  By doing so, you get broad exposure, minimal fees, and a portfolio that always wins.

 

N. Russell Wayne

Sound Asset Management

Weston, CT

Any questions: please contact me at nrwayne@soundasset.com

203-895-8877

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