I see a common strategy that many tend to employ is to pick an index like the s&p and then pick some of the stocks in the top 10 of the index that they think are good companies. The idea behind this is to get a boost by increasing the concentration of the “winners”. (I am guilty of this as well)
For example buying the VFINX and then buying Apple, Visa and Microsoft because those are great companies and being slightly overweight on these great companies should translate to an above average return.
I was curious whether history would agree with this approach. So, I went back ~30 years (a good time horizon when saving for retirement) to the year 1988 and found these were the top 10 companies by market cap in the s&p: IBM EXXON GENERAL ELECTRIC AT&T ROYAL DUTCH PETROL GENERAL MOTORS FORD PHILIP MORRIS MERCK DUPONT
I constructed 3 portfolios.
Portfolio 1: S&P 500 index only 100% VFINX
Portfolio 2: S&P 500 + the top 5 companies in the index 50/50 50% VFINX 10% IBM 10% EXXON 10% General Electric 10% AT&T 10% RoyaL Dutch Petrol
Portfolio 3: Top 5 companies in the index equally weighted 20% IBM 20% EXXON 20% General Electric 20% AT&T 20% RoyaL Dutch Petrol
You can see the results here:
Portfolio 1 had a CAGR of 10.65% Portfolio 2 had a CAGR of 10.42% Portfolio3 had a CAGR of 9.42%
You actually underperformed by using the “index plus” strategy and if you just picked the hot stocks of that year you would have lost more than 1% in annual return.
Picking winners is very hard. IBM at the time was cutting-edge tech. If you had bought it and held until now, it would have given you a CAGR of 7.82% grossly underperforming the index. GE, which probably seemed unstoppable at the time, would have done even worse at 6.74%. You would have done just as well (and better compared to GE) if you had just bought Long Term Treasuries that would have returned 7.64% CAGR.
This was a simple exercise and I’m sure you can find a myriad of exceptions but I think it illustrates the point that you most likely won’t beat the market average in the long run.
Now some of you might say that picking less well known stocks not in the index might have helped in outperforming the index.
Maybe, but most amateur investors just buy what is well known (look at what is mentioned on this and other subs). If they ventured off this path and tried to buy obscure companies they likely would do much worse because valuation is very hard.
Indexing isn’t sexy. It’s lazy. But it works.
Disclaimer: Consult your financial professional before making any investment decision.