There is no question about the ability of some investment strategists to outperform the market over time. Standard probability models tell us there will always be outliers in either direction (an approximately equal number of strategists will under perform the market over time). How largethese outlier groups tend to be depend on where you slice the bell curve. You can arbitrarily say 1%, 5%, 10%, etc.
We’re not ever going to all fit into those top echelons. In fact, most investors take a passive approach to investing in securities: they buy shares in mutual funds, or allow a financial consultant to pick their buys and sells for them. You’re almost completely dependent upon the choices of these individuals or small teams (but you retain the ability to override their choices at any time).
Passive investing, however, works best when people rely on market forces. The market will take you along with it. You can only follow the market but you’re sure to do no worse than the market and over time you will see your investments grow. But there are two ways to follow the market: you buy all the stocks yourself or you invest in an index fund. It makes no sense to replicate the work done by the fund managers. They make their picks and you don’t have to do any work.
Index funds are considered a safe investment because they track the market and don’t take big risks. Let’s examine three major index funds to see how well they have done over the past few years.
The Dow Jones Industrial Average has realized about 70% growth over the past five years despite occasional downturns. As with all market indices the DJIA could take a turn for the worst as soon as investors start pulling their money from these companies, but the index historically rebounds within 1-2 years of any significant decline. The longest recovery took about four years in the 1930s. It could be argued (and HAS BEEN by many economists) that the pre-Depression peak in 1929 was a fluke created by speculative forces that cannot operate in the market today.
Another period of dismay for investors ran from the late 1960s through the 1970s (see the chart in the previous link) when the US stock market was considered to be “stuck”. However, economists point to the US involvement in the Vietnam conflict and the Arab oil embargo as root causes for the “malaise”. These types of conditions can happen again. In fact, the United States remains embroiled in a war in Afghanistan that has lasted longer than any other war in US history. But the economy has not suffered the same way in this war as it did during the wind-down of the Vietnam War.
Of course, it is precisely for these reasons that the Dow Jones Average’s occasional volatility has been singled out as a weak indicator of value. Nonetheless, since 1980 most investors would have done well to put their money into a Dow Jones index fund and just leave it there. Let’s look at the Standard & Poor 500 index and see how it has done.
Although some people may mistakenly believe that the index ranges are important (1000-2000 for S&P 500, 10,000-17,000 for DJIA) what really matters in these charts is the amount of growth over time in the index valuations. The S&P 500 has nearly doubled its value in the past five years. Now, that can be a little misleading.
The history of the S&P 500 going back to 1960 shows that the index has had its toe-curling moments as well. There have been two periods in the last 15 years alone when the S&P 500 went into a tailspin, but it has always come roaring back. Choosing to invest in the S&P 500 after it drops precipitously is one of the best choices you can make. This index is broad and covers the US economy much better than the Dow Jones Average. And anyone who had invested $100,000 in the S&P 500 in 1960 would have over $32 million today. A $10,000 investment would have produced $3.2 million. A $1,000 investment would have produced $320,000. That $100,000 investment would have averaged almost $600K per year income.
Charts and statistics can be misleading, of course. But what we can see from the history of the S&P 500 index is that market volatility does not hurt over time. If you do not actively manage stocks (or if your picks are not working out so well) you will find it hard to justify NOT investing in the index; but it is prudent to keep a cash reserve to help you take advantage of those significant downturns. They are not predictable and so it’s unwise to try to time the market. But you can be opportunistic when an index crashes if you have held back some cash, taking a hit on growth.
The third great index for the American stock markets is the NASDAQ. This is the so-called “technology index” or exchange. Many young companies get their start on the NASDAQ and they often experience radical growth; but some NASDAQ companies burn out spectacularly, too, taking their investors with them.
A NASDAQ index fund, however, spares you the heartache of losing your nest egg when any one or even a group of companies crashes. Since 1978 the NASDAQ has experienced 50-fold growth and despite some significant downturns it has generally recovered quickly from market collapses. If your friends are telling you to stay away from the NASDAQ companies because they are so unpredictable, think about what an index fund can do for you.
There are no sure things in the stock market. And if your financial situation demands that you cash out during a bad downturn you will lose money. But that is why investment strategists don’t advise you to put everything into one investment. You could buy into all three indexes through mutual funds and earn dividends and interest while maximizing your diversity. You’ll be hurt by the biggest economic downturns but keeping a cash reserve means you can weather the storms, either by using that cash to take care of unexpected expenses or to make some opportunistic buys.
Prudent investing assumes there will be downturns and that some of your investments will turn down when you least expect them to. The less you depend on any one company to build your wealth for you, the less emotional you will be when there are problems with the market. For small and casual investors that is the best way to manage your securities strategies because fear and anxiety are your worst enemies.
