Case Study: Are Index Funds Better Than Stock Picking?

Stock Picking vs. Index Funds: What the Numbers Reveal

Two powerful books fundamentally shifted my approach to investing—The Little Book of Common Sense Investing by John C. Bogle and The Four Pillars of Investing by William Bernstein. Their core message?

“Buy a well-run index fund and own the whole market.”

This advice makes a lot of sense when you consider the advantages of index funds, particularly those tracking the S&P 500:

1. Diversification:
   Index funds spread your money across a diverse range of companies and industries, reducing the risk of any single stock dragging down your portfolio.
2. Cost Efficiency:
   With lower fees than actively managed funds or individual stock trading, more of your money stays invested, compounding over time.
3. Reliable Returns:
   Historically, index funds like the S&P 500 have delivered steady, long-term growth, outperforming most actively managed portfolios.
4. Simplicity:
   No need to analyze individual stocks or time the market. Index funds offer a straightforward and low-maintenance investment strategy.

After understanding these benefits, I began to wonder: Could individual stocks really beat the performance of an index fund such as S&P 500? To answer this, I conducted a case study, analyzing the returns of S&P 500 companies over the last decade. Using data from Wikipedia and Yahoo Finance (yfinance), I explored how individual stocks compared to index funds from 2013 to 2023.

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Motivation

The core question driving this study was: Does stock picking consistently outperform investing in index funds? By examining the distribution of returns across S&P 500 companies, I wanted to uncover whether stock picking could offer a significant edge or if the “index fund advantage” remains unbeatable.

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Case Study: Understanding Individual Stock Returns vs. Index Funds

The graph below tells a compelling story about how S&P 500 companies performed over the last decade. It highlights growth trends, outliers, and how individual stocks compare to the performance of an index fund.

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Explaining the Plot

Histogram Overview

This histogram illustrates how individual S&P 500 companies performed over 10 years. It plots the number of companies (y-axis) against their 10-year price growth yield in percentages (x-axis), revealing the variability in returns.

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Key Observations

1. Most Companies Show Modest Growth:
   Many companies cluster on the left side of the graph, with returns near or below the average price growth rate of the S&P 500 (~235%). This reflects steady but unspectacular performance for most stocks.
2. A Long Tail of High Performers:
   On the far right, a few companies stand out with extraordinary growth—sometimes exceeding 10,000%. These outliers skew the distribution and underscore how unpredictable individual stock performance can be.
3. Median Return (Red Line):
   The median return is marked at 272.24%. While this is higher than the average return of the S&P 500, it doesn’t fully account for the broader diversification benefits of the index.
4. Surprising High-Growth Probability:
   Roughly 10% of S&P 500 companies achieved over 10x growth in the last decade. This relatively high probability reveals the potential of individual stock investing, despite its risks.

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What It Means for Investors

1. High Variability:
   Returns vary widely, with only a few companies delivering extraordinary results. Predicting these winners is exceptionally challenging.
2. Risk of Underperformance:
   Without careful selection, picking individual stocks could lead to subpar returns compared to the consistent growth of an index fund.

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Key Lessons for Investors

1. Survivorship Bias:
   The dataset includes only companies that remained in the S&P 500 for the entire decade. Poor performers removed from the index are excluded, artificially inflating the median return. Index funds adjust for this naturally by rebalancing.
2. The Power of Diversification:
   Index funds spread risk across hundreds of companies, capturing overall market growth. Relying on a few individual stocks increases the likelihood of underperformance.
3. Median vs. Average:
   The median return is skewed upward by a few outliers, while the average return is likely closer to the S&P 500 index’s overall performance.

A Balanced Approach: Combining S&P 500 Stock Picking with Risk Management

For investors who want to explore individual stock picking while mitigating risk, a balanced strategy involves setting aside a small portion of their portfolio for purchasing individual stocks from the S&P 500. The S&P 500 consists of large, established companies that are generally considered reliable. However, it’s essential to regularly monitor the performance of the selected stocks and ensure they remain on the index, as being part of the S&P 500 is a sign of a company’s consistent financial health and market position. If a stock shows signs of underperformance or is removed from the index, investors may consider reallocating funds to another stock within the index or back into an index fund. This method helps reduce exposure to poorly performing stocks while allowing for the potential upside of individual stock ownership.

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Conclusion: Interpreting the Data

This case study sheds light on the risks and rewards of individual stock investing versus index funds. While the median return of individual stocks appears higher than the index’s average, this doesn’t guarantee that stock picking is a superior strategy. Variability in returns, survivorship bias, and the difficulty of consistently identifying top performers make index funds a safer and more reliable choice for long-term investors.

However, the 10% probability of finding a “10x” stock reveals the allure of individual stock investing for those willing to take on additional risk. Whether you choose the stability of index funds or the excitement of stock picking, the key takeaway remains the same: Diversification and long-term discipline are essential for sustainable investing success.

For more insights on managing your finances and growing your wealth, be sure to read our previous blog posts: Money 101: Best Budgeting Strategies for Financial Freedom and Money 102: Investment Choices for Financial Growth.

Disclaimer: This blog post is for informational purposes only and does not constitute financial advice. Please consult with a qualified financial advisor before making any investment decisions.

Written by: Ankita Pujar and Dr. Robin Garg