Index Funds - The Dumb Money Almost Always Wins

Why Brilliant Money Managers Have Trouble Beating Index Funds

One of the most surprising things about Wall Street is the failure of almost all money managers to consistently beat the Dow Jones Industrial Average (DJIA). How is it that brilliant, all-star managers (many of whom are paid six or seven figures) to outsmart the market are rarely able to beat the “dumb” collection of thirty unmanaged stocks that make up the Dow? First, allow me to provide a little background on the world’s most famous index.

The Composition of the Dow Jones Industrial Average

The Dow Jones Industrial Average (DJIA) is a list of thirty American blue chip stocks chosen by the editors of the Wall Street Journal. The Dow is price weighted, meaning that the fluctuations in one component’s share price may have a bigger or smaller impact on the index value than an equal change in share price of another component. The DJIA is the most commonly used metric to gauge American stock prices.

The current Dow components are: 3M, Alcoa, Altria Group (formerly Phillip Morris), American Express, AT&T, Boeing, Caterpillar, Citigroup, Coca-Cola, DuPont, Eastman Kodak, Exxon-Mobil, General Electric, General Motors, Hewlett-Packard, Home Depot, Honeywell, Intel, IBM, International Paper, J.P. Morgan Chase, Johnson & Johnson, McDonald’s, Merck, Microsoft, Procter & Gamble, SBC Communications, United Technologies, Wal-Mart, and the Walt Disney Company.

The Disadvantage of the Smart Money

For all the brainpower, analytical talent, research and data at the disposal of large mutual funds, there are several offsetting disadvantages that often make beating the market impossible. First, the “dumb” index funds are assumed to be held perpetually; hence, the Dow is not subject to brokerage fees or capital gains taxes. Mutual funds, however, are subject to a number of expenses and administrative costs including salaries for managers, analysts, staff, utilities, and rent. That being said, some of you have probably already realized that in order for a mutual fund to even match the market’s returns, it has to post a larger gain for the year! In other words, if the Dow is up 10%, a manager may have to increase the portfolio’s value 11 or 12% in order to offset costs and post a 10% gain.

Index Funds Provide a Solution

The old adage, “if you can’t beat them, join them” may serve most mutual fund investors well. Why attempt to beat the market when you can simply own a part of it? There is an index funds for each of the major U.S. indices – the S&P 500, DJIA, NASDAQ, Wilshire 5000, etc. Many investors would best be served by beginning a dollar cost averaging plan into one or more of these index funds and maintaining it for their entire investing lives.