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.”

-Benjamin Graham in The Memoirs of the Dean of Wall Street

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.