Why Is It So Hard to Beat an Index?
- Rudy Fichtenbaum
- 3 hours ago
- 9 min read
By Rudy Fichtenbaum April 30, 2026
To understand how the stock market works. When a company goes public, i.e., makes its stock available on a stock exchange, there is normally an initial public offering. Once that offering has been sold, the stock is available for trading daily.
Why do people or institutions trade? If one person thinks the value of a stock will increase, they buy the stock. But why would someone sell a stock? They are willing to sell because they believe the price is going to go down. Unless the price remains unchanged, which rarely happens, one person is right, and the other person is wrong. If the stock was selling for $50 a share and it goes to $51 a share the person who bought it at $50 makes $1, and the person who sells at $50 loses $1. Conversely if the price drops to $49, the person who buys loses $1 and the person who sells makes $1. This is known as a zero-sum game, because every $1 made by someone is balanced by $1 lost by someone else.
A stock index like the S&P 500 consists of the 500 (approximately) largest publicly traded companies in the U.S. I say approximately because at the moment, there are 504 stocks that make up the S&P 500, since some companies like Alphabet (Google) have multiple classes of shares. (Classes of shares in the same company exist because owners can have different voting rights. Class A of Alphabet is for ordinary investors who get 1 vote per share. Class B is for the two founders of Alphabet who get 10 votes per share. Class C is generallyfor employees who have no voting rights. George Orwell might have said, “All shareholders are equal, but some are more equal than others.”)
Stock indices are “cap weighted” . Here is what that means. First, one finds the so-called market capitalization of each company; that’s the value of all outstanding shares of the company’s stock, calculated by multiplying the price per share times the number of outstanding shares. Then, the market caps of all the companies in the index are added, giving the total market cap of the index as a whole. (The 500 companies having the largest market cap belong to the S&P 500.)
Companies that have the highest market cap (value) have the greatest weight in the index, and those who have the lowest market cap have the least value. A stock index measures the percentage change in all stock prices in the index taken together weighted by market cap. Currently, Apple has the largest market cap, $2.82 trillion; Dish Network has the smallest market cap, $3.4 billion (These market capitalizations change every day as prices go up and down, so if you are checking today when you are reading this paper the numbers I cited for market capitalization for Apple and Dish Network will almost certainly have changed). So, the largest company in the S&P 500 is about 830 times the size of the smallest company.
Today, the 7 largest companies (NVIDIA, Apple, Microsoft, Alphabet, Amazon, Meta, and Tesla in the S&P 500 (the Magnificent 7) account for approximately 33 percent of the S&P 500’s performance. If you are an investor using the S&P 500 as your benchmark and you underweight or overweight these very large stocks, you are taking a lot of risk. Why? Suppose your portfolio consisted of all the other stocks in the S&P 500 except for the Magnificent 7. If the prices of the other 72% of the companies in the index remained unchanged on a particular day and the prices of the Magnificent 7 went up by 10% then the S&P 500 would have gone up by 3.3% and the value of your large cap portfolio would have remained unchanged. In this case, you would have lost to the S&P 500 by 3.3%. If the prices of all the other companies went down by 10% while those of the Magnificent 7 remained unchanged the value of your portfolio would be down 10% compared to 6.7% for the S&P 500 index.
In 2025 the average return of the Mag 7 was 27.5% compared to 17.9% for the S&P 500 as a whole. That means that the average returns of all of the other companies, excluding the Mag 7, was 13.2%. So not holding the same percentage of shares of the largest companies in the index is going to increase your volatility, i.e., the amount of risk you are taking. If you don’t want to take this risk, you must try and hug the index and just let your portfolio differ on the margins, making your trades in the lower cap stock space. Obviously, that limits the amount you can win or lose.
So, let’s put together what we have learned so far. Trading stock is a zero-sum game, and if you don’t want to take a lot of risk, then your portfolio cannot significantly depart from that of the index used as a benchmark to measure your performance.
The final and perhaps the most important factor that makes it hard to win is that trading is not free. So even if you are lucky enough to outperform an index by a small margin, most of the time, your gain is wiped out by the fees you pay for trading and research. Recently, the New York Times published an article quoting Princeton economist Burton Malkiel, the author of the book A Random Walk Down Wall Street. In that book he said, “…a blindfolded chimp could pick stocks as well as experts…” and in the article he commented that “The historical record shows that insight is basically right… [and] It’s likely to be true in the future, too….” It is the case that stock pickers on occasion do beat the market, but the percentage who beat the market consistently is vanishingly small. The article noted that 72% of fund managers lagged the market over one year, 73% lagged over 5 years, 90% lagged the market over 10 years, and 93% lagged the market over 20 years. Why can’t fund managers beat the market? The number one reason for persistent failure of active management is higher fees compared to passively manage index funds.
Here is what Jack Bogle, the founder of Vanguard, wrote in a 2002 article in the Journal of Portfolio Management:
"You might say: So what else is new? For it must be obvious that if we take all stocks as a group, or any discrete aggregation of stocks in a particular style, an index that owns all those stocks and precisely measures their returns must, and will, outpace the return of the investors who own that same aggregation of stocks but incur management fees, administrative costs, trading costs, taxes, and sales charges. Active managers as a group will fall short of the index return by the exact amount of the costs the active managers incur."
In the same article, Bogle uses a simple test of logic to prove his point: 1) all investors taken as a group earn the market return; this is true because for every winner there must be a loser. 2) index funds earn the market return [an index is the cap weighted average of all firms comprising the “market”]. Therefore, 3) on average, active investors (non-index investors) earn the market return, but this is before expenses. Since the expenses
associated with active trading are significantly higher than for index trading, it follows that active investors as a group will underperform index investors by the difference in their expenses.
In a recent blog “The Active Management Delusion: Respect the Wisdom of the Crowd, ” Mark J. Higgins CFA, CFP wrote: “…the average manager is expected to underperform an index fund because most asset managers underperform index funds.” He then goes on to say:
"Why can’t advisers and consultants accept the truth about outperformance? Because they fear it will lead to their obsolescence. It is a great irony, therefore, that the opposite is true. Once we let go of the outperformance obsession, we can add extraordinary value for our clients. Clients need us to hone their investment objectives, calibrate their risk tolerance, optimize the deployment of their capital, and maintain strategic continuity. By spending less time on unnecessary tweaks of portfolio allocations, the constant hiring and firing of managers, and unnecessary forays into esoteric asset classes, we can better serve our clients by focusing on what really matters."
Are there years when some of the active managers outperform an index? Absolutely! When you flip a coin, everyone knows that the odds are 50-50 of getting heads or tails. So, what is the probability of getting 5 consecutive heads when you flip a fair coin? The answer is 1/32 (1/2 x 1/2 x 1/2 x 1/2 x 1/2) or 3.125% of the time. Does this mean that one can flip a coin 1,000 times and expect to get heads more or less than 500 times?
Let’s look at an example of an active manager who has beaten the S&P 500 Index. From 1965 until 2023, Warren Bu<et (Berkshire Hathaway) has beaten the S&P 500. Buffet earned an impressive 19.8% compared to 10.2% for the S&P 500 with dividend included. Over the last 20 years, Berkshire earned 9.75% compared to 9.7% for the S&P 500. And, in the last 10 years Berkshire Hathaway earned 11.8% compared to 12.0% for the S&P 500. So arguably, one of the world’s best investors has for the last 20 years just about equaled the performance of the S&P 500 but has done worse in the most recent 10 years.
About 40%-50% of Berkshire’s earnings come from a portfolio of about 47 stocks; the rest comes from insurance, rail, and oil & gas companies wholly owned by Berkshire Hathaway. The stock portfolio is about $369.9 billion, and Berkshire has cash of $157.2 billion. So, leaving out the companies that Berkshire Hathaway owns in their entirety, their investment portfolio is about $527.1 billion. So, Berkshire Hathaway’s investment portfolio is about 5.9 times the size of STRS OH.
Berkshire Hathaway’s portfolio is extremely concentrated. In 2024, one stock (Apple) accounted for 44.6% of the stocks it owned. The top 10 stocks accounted for 86.4% of the portfolio. Finally, in his 2024 report to shareholders, Bu<et said: “There remain only a handful of companies in this country capable of truly moving the needle at Berkshire, and they have been endlessly picked over by us and by others…. Outside the U.S., there are essentially no candidates that are meaningful options for capital deployment…. All in all, we have no possibility of eye-popping performance. ” So, one of the most successful investors of all-time, hasn’t beaten the S&P 500 in 20 years and underperformed for the last 10 is now saying there is no possibility for eye-popping performance which might be interpreted as saying he will not likely beat the S&P 500 going forward.
Given all this information, what is Warren Buffet’s instruction in his will for how the assets that his wife will inherit should be invested? Surely, she could go out and hire a top-notch investment firm to do her investing. Yet Buffet said, “My advice …Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. ”
Another legendary stock picker was Peter Lynch, who headed Fidelity Magellan (FMAGX) from 1977 until 1990. Using portfolio visualizer’s back test, we can compare Fidelity Magellan’s performance from January of 1985 until February of 2024 with Vanguard’s S&P 500 Index (VFINX). Indeed, over that time FMAGX outperformed the VFINX. VFINX had a return of 11.43% and FMAGX had a return of 11.54%, although, its standard deviation was 12% higher than that of the S&P 500. However, if we leave out the Lynch years (he retired at the age of 46), FMAGX returned 9.8% and the S&P 500 returned 10.25%, again with FMAGX having a standard deviation that was 12.6% higher than VFINX. Over the same period, Vanguard’s Small Cap Index (VSCIX) also beat VFINX but its standard deviation was 20.15% which was 29% higher than that of VFINX. In general, small cap stocks tend to outperform large cap stocks, which may help to explain Lynch’s success; however, they are also more risky than large cap stocks.
So, is it possible to beat an index fund? Yes, just like it is possible to flip a coin and get 5 consecutive heads or tails. But it doesn’t happen very often, and the number of managers who can consistently outperform an index over a long period of time is vanishingly small.
Throughout his career, and as an elected member of the STRS Ohio Retirement Board, Rudy Fichtenbaum has fought for the rights of Ohio's educators. As an STRS board member and Chair, he stood on the front lines to protect and restore the retirement benefits teachers have earned through decades of hard work.
Now, Rudy faces a massive personal challenge. Because of his commitment to teachers, he was targeted by a lawsuit from the Ohio attorney general, incurring over $100,000 in legal fees defending his actions as a board member. While ORTA previously provided assistance, they were forced to cease due to an investigation by the Ohio Ethics Commission. Rudy must now finance this battle on his own. We cannot let an educator stand alone after he stood up for us.
Your contribution, no matter the size, makes a difference. If you are unable to donate, please consider sharing Rudy's story and his GoFundMe campaign with your network of colleagues and friends. Together, we can ensure that standing up for teachers doesn't result in individual financial ruin.