Why is beating the S&P 500 hard? This question comes down to the tug-of-war between active vs. passive investing. In this post, I will take a look at many reasons why active fund managers lag behind the S&P 500 index. I also conclude why broad stock market ETFs such as VOO are the way to go for many small investors.

Reason #1: How the S&P 500 is Constructed

The first and most important reason why beating the S&P500 has been so hard is due to how it chooses stocks. The index committee weeds out companies based on:

• market capitalization
• profitability
• liquidity

Thus, if a company underperforms, the S&P 500 committee will drop it from the index. This approach favors relative performance by amplifying strong performance and suppressing weak returns.

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Since 2015, nearly 180 stocks were booted out and replaced with other companies in the S&P 500. That is a whopping third of the entire index. In a sense, this is unsurprising. Such actions reflects the fast-changing pace of the US economy.

For instance, Uber and Airbnb joined the index in 2023. At the same time, Lincoln National and Newell Brands were dropped. This is again not surprising given the importance of technology today. So, in essence, with the S&P 500 you can take advantage of collective wisdom and view on the US economy.

Moreover, the S&P 500 does this reconstitution in a systematic and periodic way. It is quite simple actually and may be even mechanical in a way. But, this simplicity is what makes the difference.

Conversely, it is very hard picking stocks. It is even harder to decide when to sell them. S&P 500 achieves these goals with predefined rules that do not require a lot of thinking.

Reason #2: Picking Winners is Not Easy

The second reason has to do with picking winners in general. After all, this is what active fund managers are trying to do: find alpha. But, picking them is hard. Take the Magnificent 7 stocks for instance. They appreciated by an average of 111% in 2023. In comparison, the S&P 500 total return was roughly 26% in 2023. Without the Magnificent 7, the S&P 500 total return would have been much lower, probably in the realm of 12% or less.

Morningstar calculated that S&P 500’s total returns were 12.9% from 2013-2022. What’s more, these returns would have been much worse without its top performers. For instance, without its top 10% performers, the annualized returns shrink to 3.9%. It gets even worse without the top 25% performers: the returns drop to 0.4%.

S&P 500 does pick winners over the very long-term due to how it weighs strong stocks and gets rid of losers. So, the conclusion from this is: if you do not hold top performers, it is close to impossible to beat the S&P 500.

On another note, holding anything other than a broad stock market ETFs results in narrow bets. Take VanEck Semiconductor ETF (SMH). Investing in it entails making a bet on the outperformance of the technology sector. This outperformance did happen in the last 10-15 years, but will it persist into the future? Who knows. It may very well do or not. This is why the S&P 500 or a total stock market fund such as VTI should be the core holdings of any portfolio. Other bets can be like spice to be added here and there.

Reason # 3: Timing Markets Rarely Works

The other reason why beating the S&P 500 is hard is because many people try to time markets. There are several reasons why timing rarely works as opposed to the buy-and-hold approach. First, this strategy requires investors to be in and out of stocks. This not only generates taxes, but may also prevent investors from compounding returns.

Second, timing markets is generally very hard. Even if one uses the most sophisticated technical indicators, it is still a crapshoot at best.

According to Crestmont Research, the S&P500’s up days vs. down days are about 54% vs. 46% over the very long-term. But, the big-move days are very rare. For instance, here are the stats for the past five years (2019-2023) for the up days:

• 1%+ gain: 17% of all trading days
• 2%+ gain: 3.7% of all trading days
• 3%+ gains: 1.3% of all trading days
• 4%+ gains: 0.7% of all trading days

So, if I missed these rare up days, my annual performance would have been much worse. Thus, the odds are against market timers.

Investors Takeaways

When people talk about stock picking, all eyes turn to Warren Buffett. But, even Buffett himself said:

“The weeds wither away in significance as the flowers bloom. Over time, it takes just a few winners to work wonders.”

Later, he added:

“Our satisfactory results have been the product of about a dozen truly good decisions—that would be about one every five years—and a sometimes-forgotten advantage that favors long-term investors such as Berkshire.”

So, even Buffett acknowledges that stock picking is very hard and it takes a few outstanding stocks to beat the S&P 500. Everyone talks about Berkshire Hathaway outstanding track record. But, the company had many flops that it barely escaped or which dented its performance for years. Of course, nobody talks about them.

People often ask Warren Buffett for investment advice. Here is what he had to say:

“Consistently buy an S&P 500 low-cost index fund. I think it’s the thing that makes the most sense practically all of the time.”