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Why You Can Always Beat Index Funds

Asset AllocationDouble click on any image for a full size view

There is so much talk about how index funds are better than active management that I wanted to take a couple of minutes to show you a comparison.

In the above graphic, you see the the index fund asset allocation of 60% US Stock Market (inclusive of Large Cap, Mid Cap and Small Cap weighted in the percentage of market value each plays in the total) and 40% US Bond Market (inclusive of Corporate Bonds and Treasury Bonds weighted again by percentage of market value) which is called Portfolio 1.

Portfolio 2 is a diversified asset allocation very similar to the one we have in our Fully Diversified Strategy.  It includes decisions by an investment manager (me) to allocate specific percentages of the portfolio to Growth Vs Value stocks, Large Cap Vs Mid Cap Vs Small Cap stocks, and Domestic Vs Foreign Vs Emerging Market stocks – in other words, applying the sound investment principals of risk management, relative value, and potential return, all of which are moving targets based upon the constant changes in the markets.

If you believe the hype, then Portfolio 1 will soundly outperform Portfolio 2 because no one can beat the market and that the lower fees of the index funds provide the advantage over active management.

Below is the comparison of the actively managed portfolio to the index portfolio:

Asset Allocation REturnsIf you happen to double click on the image above, you will see that the actively managed portfolio has soundly beaten the index fund portfolio.   In the example above, both portfolios had $10,000 invested in 1984.  Over the course of 30 years, the actively managed portfolio grew to $222,507 whereas the index portfolio grew to $172,387.

Now, I know some of you out there are thinking that the difference between the two is that Portfolio 1 did not include any foreign stocks and that if you add those in, the results are similar.

Nope.

Check this out:

Portfolio 3If you double click the image, you will see that we have added 15% International exposure and reduced the US exposure by the same amount.  I chose this 15% because it is roughly the same as the 16% in Portfolio 2.

Here are the returns:

Portfolio 3 returnsThe addition of 15% International Exposure to the index portfolio made no material difference in the final portfolio value:  $172,037.  In fact, the portfolio value actually dropped with the addition of International stocks.

Lastly, I also want you to see how an investment in the markets did compared to keeping the money ultra safe in a money market fund.  So, here is our new Portfolio 3, an all money market portfolio:

Money Market

The primary reason that people keep money in a money market instead of invested prudently is that they are afraid they will lose everything and end up flat broke.  However, over the course of 30 years, with multiple crashes in the stock market, inflation, wars, bad Presidents, and anything else you can think of, a properly diversified actively managed portfolio of stocks and bonds is clearly the winner.  Just take a look:

Money Market ReturnI will admit that I am biased to active management over passive index funds.  However, having an extra $50,000 in my investment account simply because I hired a competent investment manager who can balance Risk Vs Return by selecting an asset allocation that aims to minimize risk and maximize return seems like a simple decision, even for a banker.

Mark