First, a quick look at Wall Street. In early February, after a lengthy string of quarterly losses, RadioShack filed for Chapter 11 bankruptcy. After struggling to stay afloat for so long, the iconic consumer-electronics company finally failed, unable to destroy itself on the back end and reinvent itself on the front end to keep up with the dynamics of change.
Joseph Schumpeter, an Austrian-born economist, coined the term “creative destruction” in 1942 to describe the inherent challenges companies face in a free-market economy that is constantly challenging the status quo to improve the bottom line.
RadioShack isn’t the only company that has struggled with embracing creative destruction over time. Thirty years ago, the cool technology companies were named Kodak, Polaroid, Digital Equipment, Digital Switch, Telex, and Coleco, just to name a few.
Do you think Amazon, Google, and Facebook are going to be relevant 20 years from now? Maybe, but maybe not. Of the top 10 companies in the S&P 500 index in 1980, only two (Exxon and General Electric) made the list in 2000, and only Exxon, GE, and Microsoft had maintained a 2000 top-10 ranking at the end of 2014.
Enough of Wall Street. How about you, and your mission to build wealth? Trying to keep up with creative destruction through active stock and mutual-fund selection is not only a futile endeavor, but likely to cost you dearly in portfolio returns over a lifetime. Richard Foster and Sarah Kaplan, in their 2001 book Creative Destruction, reveal that of the 500 companies that made up the initial S&P 500 list in 1957, only 74 remained by 1998, and of those, only 12 companies (less than 3 percent!) outperformed the index over that period.
When you pursue the top-performing companies for your portfolio, not only are you faced with the guesswork caused by creative destruction, but you don’t really own the growth and profitability of the company anyway. Sure, you might legally own shares, but you are not investing in a company’s financial success, because the company doesn’t have anything to do with the price of its stock. You own the emotions of thousands of other investors who, minute by minute, set the price of the stock and in turn are betting that they can outsmart you and your expectations for the company.
The notion that you or a professional stock picker can consistently select top-performing companies over a lifetime of investing is a myth. Picking a long-lasting top performer only happens through blind luck. As Foster and Kaplan write, “An investor following the logic of patiently investing money in these survivors will do substantially less well than an investor who merely invests in market index funds.”
Instead of wasting time trying to identify the few companies that will outperform the market as a whole, a smarter way to build a portfolio is to invest in the collective creativity of human beings through low-cost, tax-efficient index funds.
In your journey to reinvent yourself and keep up with companies that are creatively destroying themselves to keep up with you, there is no time to waste. Making the right choices in your portfolio today to maximize returns tomorrow is an essential component of financial security.