401(k) Notes

Here is how the funds in our 401(k) have done so far this year, as of September 30 [1998].

Compared to performance in recent years, this looks rather lackluster (and Emerging Markets looks considerably worse than lackluster) but it's interesting to see that despite all the turmoil in the US stock market, the Index 500 is still up 9%, putting it on track to make about 12% for the full year -- or about 2% more than the historical average for the US market.

The Emerging Markets fund is in the cellar, due in part to the Asian economic turmoil. Emerging markets, though, are highly volatile and have a tendency to come roaring back when everyone least expects it. From 1945 to 1991, emerging-market stocks averaged 18.5% compared to 11.8% for US blue-chip stocks, and if they begin to revert to that average it will be a happy development for investors who bought them when they were low. One more point: although our fund is down 29% so far this year, it's at least somewhat heartening to know that Fidelity's emerging markets fund is down 35% and Montgomery's (sometimes said to be the best in the field) is down 41%.

Jonathan Clements, my favorite investment writer (along with Andrew Tobias) has had a couple of recent columns in the Wall Street Journal that make strong arguments on behalf of index funds. (Three of the four stock funds in our 401(k) plan are index funds. Vanguard International Growth is actively managed.)

In the first, he addresses the argument that when stocks are going down, "It's a stock picker's market" -- i.e., that a fund manager carefully picking individual stocks will outperform an index fund. Mathematically, he points out, this cannot be true, because whether the market is going up or down stock pickers can only succeed at the expense of other stock pickers, and an index fund (so long as its expenses are low, as Vanguard's are) will tend to outperform the average investor.

It seems to be true that stock pickers do better in a falling market, Clements says, because when many people think of index funds they think of funds that track the S&P 500. But the 500 big companies in the S&P 500 are not the whole market. Most actively managed (non-index) funds invest in somewhat smaller companies, and in a market downturn that hurts the big companies, an S&P 500 fund like the Vanguard Index 500 may do worse for a while than the average actively managed fund. This doesn't mean that stock pickers have any advantage over indexers in a falling market -- it just means that big stocks are temporarily out of favor. (And though Clements doesn't say so explicitly, it means that a small-cap index fund like ours should do as well or better than the average actively managed stock fund.)

In another column, Clements points out that when the market goes up, a handful of stocks will account for the lion's share of the gain. On average over the past 12 years, the 50 top-performing stocks in the S&P 500 have accounted for half of the total gain for the index. For the first half of 1998, if you threw out the top 50 stocks in the S&P 500 the total return would actually drop from 17% to less than 7%.

The lesson, once again, is that it's tough -- and expensive, risky, and time-consuming -- for a fund manager, or for you, to beat the performance of a good low-cost index fund by picking individual stocks. Despite the current sobering figures, our own funds are performing well against the competition and should continue to do so.

Published in Bread and Cutter, November 1998.