The Case for Indexing: The 80/20 rule applies!

by Wayne Ferbert on December 7th, 2011

I am currently reading an excellent book titled The Ivy Portfolio. The book is an excellent complement to our book, Buy And Hedge: The Five Iron Rules for Investing Over the Long Term. When I finish it, I will write a longer review and post it on this blog.

The Ivy Portfolio focuses on asset allocation techniques - which is what makes it such an excellent complement to our book. In our book, we teach a basic asset allocation approach - but if you want to fine tune your asset allocation, this book can help you. The book focuses on the correlation and historic return / risk (volatility) profiles of the different asset classes - including some that we don't cover in our book: commodities, hard assets, real estate, private equity, & hedge funds.

But one thing we do have in common with this book: we both believe in indexing for the individual investor. And the authors of this book cite a study that really drives home the importance of indexing for the Individual Investor.

The study, by Blackstar Funds, examines the total returns of all of the stocks in the Russell 3000 Index from 1983 to 2008. The top performing 20% of the stocks had returns over this time period in excess of 300%! The bottom performing 20% had returns of -75% and worse. In fact, 40% of the stocks had a negative return over this time frame!

The mathematical importance of this study is that the 80/20 rule applies!! The top gaining stocks drive the majority of the total return of the Russell 3000 Index over this time period. And unless you were lucky enough to have picked the 1 in 5 stocks that were the winners, that means you would not have captured the majority of the gains in the market.

In other words, like we mention in our book, picking stocks is very difficult. And the nature of capitalism is that a select handful of companies drive most of the business in most industries. Picking these companies can be difficult. Being good at picking these companies in an industry outside your area of expertise: even more difficult!

The key conclusion: By being invested in the broad index, you are sure to capture the excess returns in these top performers because these top performers are always captured by the index (along with the losers, of course).

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