Author Archive E-mail Author Send to a Friend <% dim printurl printurl = Request.ServerVariables("URL")%> Version

December 12, 2002 8:00 a.m. Don’t Be a Scrooge of Stocks Index funds tell a long and happy story.

y favorite curmudgeon, the Scrooge of Stocks, is a former National Geographic photographer named Charles Allmon. He lives in Potomac, manages about $100 million for clients, and is the founder and editor of Growth Stock Outlook, now in its 38th year.

When I first met him a couple of decades ago, Allmon was a bull. He actually owned a lot a growth stocks, hence the name of his newsletter. But as the 1980s wore on, he became more and more gloomy. His great coup was predicting the 1987 crash two months before it happened, but, as Business Week put it, "The trouble is, Allmon has remained bearish ever since." Since October 1987, the Dow Jones industrial average has gone from 1,700 to over 11,000 and lately to 8,700, but Allmon thinks it's too expensive. Last week, 78% of his assets were in cash.

We're poles apart in our view of the future of stock prices, but I love his newsletter, which always has a glistening nugget or two. The latest issue offers a little sidebar with this amazing fact: Since June 27, 1973, the date Allmon started publishing a model portfolio, the Wilshire 5000 index has returned 2,322% while the Standard & Poor's 500-stock index has returned 2,247%.

In other words, over 28 1/2 years, these two portfolios — one currently comprising more than 6,500 stocks; the other just 500 — have produced almost precisely the same gains. Start with $10,000 in 1973, and you would have $242,220 with the Wilshire and $232,470 with the S&P — a difference of just 4%. And, by the way, during this period, Allmon's own portfolio rose to $240,000.

These figures offer two important lessons for investors.

First, over a generation that included rampant inflation, high interest rates, several severe recessions, the worst one-day crash in history, two major wars, and a calamitous terrorist attack, stocks nonetheless generated gigantic gains.

Second, over time, as the title of a Flannery O'Connor book puts it, "Everything that rises must converge." Put together an intelligent diversified portfolio, and, chances are, it will come close to performing the way that the market averages do. As a result, the argument for putting your money into a low-cost index fund is a powerful one. After fees, about two-thirds of managed U.S.-stock mutual funds failed to beat the S&P over the past 10 years. Part of the reason, as I pointed out last week, is that many fund managers trade too much and make poor choices; the other part is the fees themselves.

I haven't completely given up on managed — that is, human-run, as opposed to computer-run, mutual funds. I still think a few gifted managers can beat the market with consistency. But how much time and effort should a small investor expend in trying to ferret out such geniuses? And, since past performance is no guarantee of future success, is there even a rational way to find them?

As usual, the best wisdom on the subject comes from Warren Buffett, who wrote in the 1993 annual report of the company he chairs, Berkshire Hathaway, that by "investing in an index fund, the know-nothing investor can actually outperform most investment professionals." He added: "Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb."

Buffett was not using "dumb" in a pejorative sense. He was simply saying that many people aren't inclined toward learning about businesses and markets. For them, computer-managed index funds, a gift of this technological age, are just fine.

The reason to invest in an index fund is that the U.S. stock market is a proxy for the U.S. economy, which, in all its robust diversity, has been the best economic bet on the planet for the past century or so.

The problem is that there's no single method of defining the U.S. stock market. The Wilshire 5000 total market index, maintained by Wilshire Associates, a Santa Monica, Calif., investment advisory firm, tries to capture every common stock listed on the three major exchanges — at last count, about 7,000 of them. Wilshire's website properly claims that the index is "the best measure of the entire U.S. stock market."

The Wilshire, like the S&P 500, is "capitalization-weighted," which means that the influence of an individual stock on the overall index is determined by its market cap, or value according to investors. (To calculate a stock's market cap, multiply its price by the number of shares outstanding.) As of last week, the five largest U.S. companies by market cap were, in order, Microsoft (MSFT), General Electric (GE), Wal-Mart Stores (WMT), Exxon Mobil (XOM), and Pfizer (PFE). Together, their capitalization was about $1.2 trillion, compared with a total capitalization of $9 trillion for all the Wilshire stocks.

A second approach to buying the market is to own the S&P 500, another market-cap-weighted index, composed (with a few exceptions) of the 500 biggest U.S. companies. As Standard & Poor's says on its website: "The S&P 500 focuses on the large-cap sector of the market; however, since it includes a significant portion of the total value of the market, it also represents the market."

In other words, 500 stocks stand for 7,000 stocks. And they do. At last report, the total market cap of the S&P was $8.5 trillion — or more than 90% of the market cap of the Wilshire.

— James K. Glassman is a fellow at the American Enterprise Institute and host of TechCentralStation.com. This column originally appeared in the Washington Post.