HOW DO YOU CAST your lot with business? Simply by buying a portfolio that owns shares of every business in the United States and then holding it forever. This simple concept guarantees you will win the investment game played by most other investors who—as a group—are guaranteed to lose.

Please don’t equate simplicity with stupidity. Way back in 1320, William of Occam nicely expressed the virtue of simplicity, essentially setting forth this precept: When there are multiple solutions to a problem, choose the simplest one.¹ And so Occam’s razor came to represent a major principle of scientific inquiry. By far the simplest way to own all of U.S. businesses is to hold the total stock market portfolio or its equivalent.

Occam’s razor: When there are multiple solutions to a problem, choose the simplest one.

For the past 90 years, the accepted stock market portfolio has been represented by the Standard & Poor’s 500 Index (the S&P 500). It was created in 1926 as the Composite Index, and now lists 500 stocks.² It is essentially composed of the 500 largest U.S. corporations, weighted by the value of their market capitalizations. In recent years, these 500 stocks have represented about 85 percent of the market value of all U.S. stocks. The beauty of such a market-cap-weighted index is that it never needs to be rebalanced by buying and selling shares due to changing stock prices.

With the enormous growth of corporate pension funds between 1950 and 1990, the S&P 500 was an ideal measurement standard, the benchmark (or hurdle rate) that would be the comparative standard for how the professional managers of pension funds were performing. Today, the S&P 500 remains a valid standard against which to compare the returns earned by the professional managers of pension funds and mutual funds.

The Total Stock Market Index

In 1970, an even more comprehensive measure of the U.S. stock market was developed. Originally called the Wilshire 5000, it is now named the Dow Jones Wilshire Total Stock Market Index.³ It now includes some 3,599 stocks, including the 500 stocks in the S&P 500. Because its component stocks also are weighted by their market capitalization, those remaining 3,099 stocks with smaller capitalizations account for only about 15 percent of its value.

This broadest of all U.S. stock indexes is the best measure of the aggregate value of stocks, and therefore a superb measure of the returns earned in U.S. stocks by all investors as a group. As just indicated, both indexes hold the very same large stocks. Exhibit 3.1 shows the 10 largest stocks in each, and their weights in the construction of each index.

Given the similarity of these two portfolios, it is hardly surprising that the two indexes have earned returns that are in lockstep with one another. The Center for Research in Security Prices at the University of Chicago has gone back to 1926 and calculated the returns earned by all U.S. stocks. The returns of the S&P 500 Index and the Dow Jones Wilshire Total Stock Market Index parallel one another with near precision. From 1926, the beginning of the measurement period, through 2016, you can hardly tell them apart (Exhibit 3.2).

For the full period, the average annual return on the S&P 500 was 10.0 percent; the return on the Total Stock Market Index was 9.8 percent. This comparison is what we call period dependent—everything depends on the starting date and the ending date. If we were to begin the comparison at the beginning of 1930 instead of 1926, the returns of the two would be identical: 9.6 percent per year.

Yes, there are variations over the interim periods: the S&P 500 was much the stronger from 1982 to 1990, when its annual return of 15.6 percent outpaced the Total Stock Market Index return of 14.0 percent. But since then, small- and mid-cap stocks have done a bit better, and the Total Stock Market Index return of 10.2 percent per year narrowly exceeded the 9.9 percent return of the S&P 500. But with a long-term correlation of 0.99 between the returns of the two indexes (1.00 is perfect correlation), there is little to choose between the two.⁴

Returns earned in the stock market must equal the gross returns earned by all investors in the market.

Whichever measure we use, it should now be obvious that the returns earned by the publicly held corporations that compose the stock market must of necessity equal the aggregate gross returns earned by all investors in that market as a group. Equally obvious, as will be discussed in Chapter 4, the net returns earned by these investors must of necessity fall short of those aggregate gross returns by the amount of intermediation costs they incur. Our common sense tells us the obvious, just what we learned in Chapter 1: Owning the stock market over the long term is a winner’s game, but attempting to beat the stock market is a loser’s game.

A low-cost all-market fund, then, is guaranteed to outpace over time the returns earned by equity investors as a group. Once you recognize this fact, you can see that the index fund is guaranteed to win not only over time, but every year, and every month and week, even every minute of the day. No matter how long or short the time frame, the gross return in the stock market, minus intermediation costs, equals the net return earned by investors as a group. If the data do not prove that indexing wins, well, the data are wrong.

If the data do not prove that indexing wins, well, the data are wrong.

Over the short term, however, it doesn’t always look as if the S&P 500 (still the most common basis of comparison for mutual funds and pension plans) or the Total Stock Market Index is winning. That is because there is no possible way to calculate precisely the returns earned by the millions of diverse participants, amateur and professional alike, Americans and foreign investors, in the U.S. stock market.

In the mutual fund field, we calculate the returns of the various funds, counting each fund—regardless of the amount of its assets—as a single entry. Since there are many small-cap and mid-cap funds, usually with relatively modest asset bases, at times they may have a disproportionate impact on the data. When small- and mid-cap funds are leading the total market, the all-market index fund seems to lag. When small- and mid-cap stocks are lagging the market, the index fund looks formidable indeed.

Active funds versus benchmark indexes.

The obvious solution to the challenge of comparing active equity funds of all types with the S&P 500 Index is to measure funds against other indexes that more closely reflect their own investment strategies. Some years ago, the S&P Indices versus Active (SPIVA) report began to do exactly that. The report provides comprehensive data comparing active mutual funds grouped by various strategies with relevant market indexes. In its 2016 year-end report, SPIVA extended the longest time horizon evaluated in the report to 15 years (2001–2016) and reported the percentage of actively managed funds that were outperformed by their relevant benchmark indexes. The results were impressive (Exhibit 3.3). On average, an astonishing 90 percent of actively managed mutual funds underperformed their benchmark indexes over the preceding 15 years. The index superiority was consistent and overwhelming.

The S&P 500 outpaced 97 percent of actively managed large-cap core funds. The S&P 500 Growth and Value indexes are used as comparisons for funds in those large-cap categories, and so on for the three mid-cap categories and the three small-cap categories. The sweeping across-the-board superiority of the indexes can leave little doubt that index funds are here to stay.

In 1951, I wrote in my senior thesis at Princeton University that mutual funds “can make no claim to superiority over the market averages.” Sixty-six years later, that has proven to be a huge understatement.

The record of an investor in the first index mutual fund: $15,000 invested in 1976; value in 2016, $913,340.

The recent era not only has failed to erode, but has nicely enhanced the lifetime record of the world’s first index fund—now known as the Vanguard 500 Index Fund. It began operations back on August 31, 1976. Let me be specific: at a luncheon on September 20, 2016, celebrating the 40th anniversary of the fund’s initial public offering, the counsel for the fund’s underwriters reported that he had purchased 1,000 shares at the original offering price of $15 per share—a $15,000 investment. He proudly announced the value of his holding that day (including shares acquired through reinvesting the fund’s dividends and distributions over the years in additional shares): $913,340.⁵ Now, there’s a number that requires no embellishment. But it does demand one caveat and one caution.

A caveat and a caution.

The caveat: Of the 360 equity mutual funds in existence when the first index fund was formed in 1976, only 74 remain. Actively managed funds come and go, but the index fund goes on forever. The caution: During that four-decade period, the S&P 500 Index grew at an annual rate of 10.9 percent. With today’s lower dividend yields, the prospect of lower earnings growth, and aggressive market valuations, it would be foolish in the extreme to assume that such a return would recur over the next four decades. See Chapter 9, “When the Good Times No Longer Roll.”

The past record confirms that owning American business through a broadly diversified index fund is not only logical but, to say the least, incredibly productive. Equally important, it is consistent with the age-old principle of simplicity expressed by Sir William of Occam: Instead of joining the crowd of investors who dabble in complex algorithms or other machinations to pick stocks, or who look to past performance to select mutual funds, or who try to outguess the stock market (for investors in the aggregate, three inevitably fruitless tasks), choose the simplest of all solutions—buy and hold a diversified, low-cost portfolio that tracks the stock market.