Fun with Indexes

Index investing is all the rage today.  Many experts say that the costs are lower, active managers can’t match their returns, and since you own the “market” you can never underperform.  You can’t actually invest directly in an index.  Instead you can use mutual funds or Exchange Traded Funds (ETFs) that mimic an index.  Most of the time the return of an index fund or ETF will be very similar to the return of the index itself.  You will have to decide which indexes to use because there are hundreds of indexes and they do not all have the same return or risk characteristics.  You also have to decide on an investment allocation (think diversification).  How much of each index are you going to hold?

Below are the main indexes I think most investors should consider.  I have used ETFs as the investment vehicle and included large stocks, small stocks, international stocks, bonds, real estate and gold.  Note the wide variation in returns for any given time period.  Look at the year that just ended – 2014.  The S&P 500 had a great year – up over 13%.  Bonds did well and so did real estate.  Small stocks only returned 5% though, and international stocks, emerging market stocks, and gold actually lost money.  

 
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What kind of returns might you have achieved with a buy and hold portfolio of index ETFs for different time frames?  Below are three hypothetical portfolios I created using the indexes above.  

 
 

The aggressive portfolio return for 2014 is only 3.3%.  Over 10 years (starting 1/1/05), all the annualized portfolio returns are between 5.9% and 6.6%.  Not exactly exciting, but reflective of two drawbacks to using index funds.  First, in a downturn (like 2008), indexes remain fully invested.  There is no manager to look at market conditions and possibly protect your capital.  Second, even though an index will not underperform its “market”, it will also never outperform. 

In my opinion, maintaining a diversified portfolio of index funds / ETFs with a buy and hold strategy condemns your long-term investment performance to average or below average returns.