How to Beat the Market, Factor 3b: Avoid the Biggest Companies, Remember Dow vs S&P

Dow vs S&P 500 total return, 1950-2018

“Buy a low cost, passive index fund, and hold it for the long term” is probably one of the most mainstream pieces of investment advice circulating over the past 40 years.  While I agree this is a better solution for most busy investors than the high overhead, high fee, and high turnover investment products that still have huge marketing budgets behind them, I believe that interested investors can easily do better than the big low cost index funds (which I sometimes call the “Big Mac” funds for being cheap and mass-produced, but able to solve world hunger) by simply avoiding the biggest stocks that are overbought by the big funds.

The simplest and longest example I can show of this is the total return chart of the Dow vs S&P (Dow Jones Industrial Average vs the Standard and Poor’s 500 stock indices) from 1950 to 2018.  Over this 68 year period, the S&P “only” outperformed the Dow by about 1% per year, but this 1% per year compounded is the difference between a $10,000 investment growing to $15.1 million vs only $7.8 million over an investor’s career.  The big difference between the two is that the Dow is only made up of 30 companies, which together have probably made up between 10% and 40% of the S&P 500 index’s total value over that period.  The other 60-90% of the broader index tracks the total return of smaller companies, which simple math tells us would have done significantly better than the S&P simply by not owning the lagging large cap components of the Dow.

Dow vs S&P 500 total return, 1950-2018
Dow vs S&P 500 total return, 1950-2018, Source: Bloomberg

This pattern of larger returns from smaller companies has also been seen in Japan over the past 20 years:

Japan's TOPIX Core 30 vs 100, 1000 and Midcap 400
Japan’s TOPIX Core 30 vs 100, 1000 and Midcap 400, Source: Bloomberg

Here is how the new TOPIX index series is designed:

TOPIX Core 30 vs TOPIX 100, 1000, Mid 400 and Small Cap
TOPIX Core 30 vs TOPIX 100, 1000, Mid 400 and Small Cap, Source: Wikipedia

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