We are often told that most people can’t beat the market. And the corollary to that is that we should all buy index funds. An index fund is safer, because with an index fund you are diversified and you’ve minimized your risks. But there’s a downside to index funds as well. The more stocks you own (and an index fund represents an investment in many, many stocks), the worse your overall returns will be. That’s because an index fund is, by definition, a mediocrity. With an index fund you own the good, the pretty good, the average, the below average, and the awful.
Can you beat an index fund? A great way to find out is to play Motley Fool CAPS. In this stock-picking game, you pick the stocks that you think will “beat the market.” And the software tracks your stock picks versus the S&P 500 index. I’ve been playing CAPS for many years, and it’s given me confidence that my stock picks will indeed beat the market over time. Here’s why individuals who pick stocks can and do outperform the market.
1. Index funds are limited
An index fund limits itself to a category, and then buys all the stocks in that category. When people talk about “the market,” they are usually talking about the U.S. stock market. It’s one of the strongest markets in the world, if not the strongest. So if you were to buy an index fund in Australia or Nigeria, your returns would be limited to the overall returns in those markets.
Some of the most popular index funds track the 500 American large-caps. These funds own shares in 500 companies in a variety of major industries in the U.S. economy. A large-cap stock is one that has been a big winner over time. So if you buy an index fund that tracks 500 large-cap stocks, you’re investing in the most successful U.S. companies.
How can an individual investor hope to do better than that? Actually there are a couple of ways.
2. Some sectors are stronger than others
A major index fund protects you with diversity. With an index fund, you’re going to have a partial interest in many tech stocks, yes, but you’ll also own oil stocks, grocery store chains, airplanes, accounting firms, and more. Not all of these sectors are as dominant (or fast-growing) in the U.S. economy as tech stocks.
For many years there was a fad of buying FAANG stocks, an acronym that represented shares of Facebook, Amazon ( AMZN -1.38% ), Apple, Netflix, and Google. Facebook is now known as Meta Platforms, and Google has become Alphabet, so the acronym doesn’t work anymore. But for many years, investors in FAANG stocks outperformed the larger market.
That’s because tech stocks overall have had fantastic returns over the last several decades. Many tech companies are growing fast. And technology — particularly software — has very high profit margins for mature businesses. So tech stocks have been very popular investment vehicles, and…
Read More: What Is This “Market” That Stock Pickers Keep Trying to Beat?