How Index Funds Handle Tough Markets

One criticism of index funds as a long-term investment tends to be a perverse kind of compliment.

“You’ll never beat the market that way,” some say. Yes, that’s right. You won’t. But the fact is, nobody else does either, and they pay a pretty penny trying.

Over five-year periods, basically no actively managed mutual funds are able to demonstrate — after fees — any kind of consistent ability to “beat the market.”

One or two can do it, out of thousands out there, but your chances of choosing those funds at the right point in their trajectory as an investment vehicle is essentially zero.

The rest, sadly, fall far short of the market averages year after year, largely because of their hefty fees, costs you shoulder as an investor whether the fund has a good year, a bad year or anything in between.

“Well,” critics will say, “indexing sounds fine in a bull market, but what about when stocks drop?”

The honest, obvious answer is, the index fund will drop, too. But actively managed mutual funds don’t own some magical alternative investment. They hold stocks, too.

Chances are, they hold far fewer stocks than the index fund. That concentration of investments often means that actively managed funds have bad years even in good times.

Sectors they prefer go out of fashion. Macroeconomic events intervene and make things hard for their chosen few investments.

Other times, they are rewarded for a narrow focus, but too often the only way to win here is to be the earliest investor in and to get out well ahead of the crowd.

That’s nearly impossible. If you manage to do it once, even twice, that’s nearly a miracle. Then the third time comes around and wipes out the gains from the first two victories, plus some extra.

Square one

You’re back to square one, or perhaps negative one. That’s why actively managed fund investors can go a decade and then wonder why they so dramatically underperform the market as a whole.

Meanwhile, the index fund investor is keeping costs low and reinvesting over the years. When stocks are expensive, more money goes into bonds and other non-equity holdings. When things reverse and stocks are cheap, the opposite happens.

Compounding takes care of the rest. That’s where the real gains come from when investing for the long term: Reinvested dividends and compounding. Not stock picking. Not forecasting and sector bets.

It’s not “interesting” to do this kind of investing. It’s not a hobby people really cotton to. But index funds work and they work well, if your aim is to retire on time.