Excerpted from Common Sense on Mutual Funds by John C. Bogle, pages 119-121

Despite its overall success, there were three periods in which the Index lagged, as reflected in Figure 5.2: 1965-1968, 1977-1980, and 1991-1993. Why? The first period included the go-go era of investing, when extremely risky small stocks provided extraordinary returns, and the mutual fund industry responded by creating large numbers of highly aggressive go-go funds. The conservative character of the industry changed during this period; funds accepted uncharacteristically high risks, and the S&P 500 Index's more modest short-term rewards made it look inadequate. The perception grew that mutual fund managers could easily outpace the market. However, when the go-go bubble burst in 1968, these newly formed funds collapsed, the returns of the average fund slumped, and the S&P 500 Index reclaimed its wide margin of superiority in 1969 through 1976.

The second aberration occurred quickly thereafter. In 1977-1980, as the stock market continued to emerge from its decline in 1973 and 1974 - an amazing 50 percent, from high to low - smaller stocks finally returned to the fore. Their recovery was rather later than that of their large-cap cousins. And three of the large stocks that then dominated the S&P 500 Index (IBM, 7.2 percent; AT&T, 6.4 percent; and General Motors, 2.6 percent), but were held in much smaller proportions by the highly diversified mutual funds, did particularly badly. On average, they turned in a four-year cumulative return of 7 percent, compared to a stunning 69 percent gain for the remaining stocks in the Index. (Overall, the Index cumulative gain was 55 percent.) As in the aftermath of the go-go era, the situation then began to return to normal, and the Index reasserted its strength for the next eight years.

Then came the most recent period of an S&P 500 Index shortfall. The primary reason was elemental. During 1991-1993, small and midsize stocks did better than large stocks. The S&P 500 gained a respectable 15.6 percent annually during this period, but the rest of the market rose at the rate of 22.5 percent. As a result, the S&P 500 Index outpaced only (if that is the right word to describe what is in fact not so far from a parity of return) 44 percent of all actively managed funds - less (but not much less) than one-half. (The all-market Wilshire 5000 Equity Index, with a return of 17.7 percent, outpaced 53 percent of the equity funds.) That shortfall, however, was quickly followed by the largest sustained margin of superiority the S&P 500 Index has ever achieved. During 1994-1998, the S&P 500 Index outpaced 75 percent to 90 percent of managed funds over four consecutive years.

After such a sustained run, it would hardly seem surprising if the large-stock-dominated S&P 500 Index were to take a pause. It continues to be dominated by large companies that are global in reach, including General Electric at 3.1 percent of the weight of the Index capitalization; Microsoft, 2.4 percent; Coca-Cola, 2.2 percent; Exxon, 2 percent; and Merck, 1.6 percent. However, it is less concentrated. Today's five largest stocks account for 11 percent of the Index, only half the 22 percent weight of the five largest industrial giants of two decades ago. Those five former leaders, interestingly, now represent only 8 percent of the Index's weight. This large reduction in their importance underscores that the sheer force of indexing has succeeded in overcoming this potential impediment. For new and growing companies have picked up the slack, enabling the Index to maintain its long-term performance leadership.

As the markets march on, times change and conditions change. And faith in an indexing strategy based on the widely celebrated success of the Standard & Poor's 500 Index will inevitably be tested from time to time in the years to come. Still, as a long-term strategy, it remains compelling.