Benjamin Graham and the Wisdom of Index Funds

This is a guest post by Mike of The Oblivious Investor. If you like what you see here, please consider subscribing to his RSS feed.

“I have little confidence even in the ability of analysts, let alone untrained investors, to select common stocks that will give better than average results. Consequently, I feel that the standard portfolio should be to duplicate, more or less, the DJIA.”

The recommendation to track an index rather than pick stocks may sound somewhat surprising coming from the man who wrote one of the most well-respected books ever written about picking stocks. However, as more and more investors are learning every year, index funds make a lot of sense compared to the alternatives.

Why not pick stocks?

The primary reason you shouldn’t pick stocks is that it’s a lot harder than it looks. Essentially, for a stock to outperform the average market return, the company needs to do better than the market expects it to do.

In other words, it’s not enough to know that Google’s profits are going to grow over the next decade. Why? Because the market already knows that. In order for Google’s stock to outperform the market, the company’s profits will have to grow faster than the market expects them to.

In short, in order to succeed at picking stocks, you need to know something that the market doesn’t know. And the market is pretty darned smart.

Why not use actively-managed funds?

Short answer: You should avoid actively managed funds because they cost too much. This is especially true offunds with sales loads.

Example: Let’s say that the market earns a 9% annual return over a given decade. If market investors incur an average of 1.5% per year in investment costs — a conservative estimate for investors in actively-managed funds — then the average dollar invested in the market will earn a net return of 7.5%. Simple math, right?

In contrast, if a person had invested in an index fund — with a typical expense ratio of 0.2% — she would have earned a return of 8.8%. That’s significantly better than the 7.5% that most investors would be earning with their actively-managed funds.

Ironic, isn’t it? Shooting for average puts you above average.

Are index funds impossible to beat? No. But they do provide you with a near certainty that you’ll outperform the majority of actively-managed funds over an extended period. I’m not aware of any other investment that can make such a claim.

Why does Graham suggest the Dow?

I suspect that the only reason Graham suggests the DJIA over any broader index (such as the S&P 500) is that Memoirs was written prior to the creation of the first index fund. Recreating an index such as the S&P 500 using individual stocks would have been nearly impossible for an individual, whereas a typical investor could probably replicate the Dow without too much trouble.

If Graham were alive today, I imagine that he’d be writing at least as much about index funds as about picking stocks.

7 Responses to “Benjamin Graham and the Wisdom of Index Funds”

  1. Anonymous

    Jacob: You bring up a great point. Portfolio turnover definitely plays a role in increasing expenses. That’s yet another point in favor of index funds over actively managed ones.

  2. Anonymous

    While I wholeheartedly agree with your article, I am fuzzy on the math. I literally just did a presentation for class on this fact. The expense ratios are calculated based not just on your assets, but the gains you also receive. So if you have an asset increase of 10%, your total end assets would equal 110% of the original investment. Then an expense ratio of 1.5% is based off of the 110%.

    $10,000 (Investment at 10% Interest)
    $11,000 (Final Worth)
    -$165 (1.5% on 110%)
    $10835 which means 1.65% removed from your actual investment. Which means an actual interest rate of 8.35%.

    I originally thought it was just a direct subtraction, but after deeper research, I turned up this fact. It is because the 10% interest is based off of original investment, and the expense is subtracted from investment plus interest or 110% of investment in this case.

    Oh, and another little fun fact. Hidden costs that are passed onto the investor in mutual funds (through Turnover, Market Impact [bid spreads], and loads) actually push the average expense on mutual funds up to about 3%.

  3. Anonymous

    Baker: Thanks for the kind words. Good luck with your journey towards being debt free.

    DDFD: Precisely. Most of us just won’t put in the time, nor can we afford the risk.

    RJ Weiss: Great video! Hadn’t seen that before; thank you for sharing it.

  4. Anonymous

    Good post.

    For most people this is the way to go . . .

    Picking individual stocks is difficult and dangerous . . .

    It requires doing your homework and analytical skills most people just don’t possess– even then, it requires assuming risks most people can’t afford to take.

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