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Stock Strategist

How Stock-Pickers Can Outperform Index Funds

A strategy to beat the market using 10 stocks and a 'coffee can.'

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At Morningstar, we've long extolled the virtues of index funds, and with good reason. Low costs and an ability to avoid underperforming the market are no small feats. However, we think that investors who are willing to invest a little time to assemble a portfolio of attractively valued, high-quality companies can outperform an index fund--with lower expenses. Our strategy? A "coffee can" portfolio, which neatly marries the benefits of indexing with the value stock-picking can create. Below, we'll stash some of Morningstar's equity research into a coffee can strategy and suggest a 10-stock portfolio that we think a stock-picker could buy today with a high probability of outperforming the market indexes over the next decade. But before we do that, let's review the competition.

The Virtues of Index Funds
And indeed, index funds present brutal, ever-present competition for stock-pickers. Recent  Morningstar research concluded that index funds based on the S&P 500 delivered higher returns than about 75% of all actively managed large-blend funds over the past decade. By buying the stocks in a representative index like the S&P 500 and simply holding them, an index fund can easily provide market-matching returns. What's more, the best index funds do this at very low cost, thanks to low turnover, the absence of research expenses and fewer capital gains taxes. As costs are a critical drag on investment returns, investors with below average costs are more likely to reap above-average returns. So investors who don't want to make frequent investment decisions can simply buy an index fund, and sleep soundly knowing their returns will match the market.

Dreyfus Neenan does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.