One of the misconceptions people have about index investing is that the return of the stock market indexes is “average” and no better. Why would I want the market return, they ask? Isn’t it better to beat the market?
Sure, it’s better to beat the market — but that’s the reason why the market return is so great. It’s nearly impossible to beat the stock market average consistently, so hard that the extremely few professional managers who can do it, even after accounting for their fees, get the big bucks.
Yet even the pros lose sometimes and when they do, they can lose big. Famous names in the investing business tend to have an expiration date stamped on them, usually related to how long their particular style of investing keeps working.
That might be a few years in a row. Then a few years not. Some investing gurus reappear every decade or so, spending the interim lost in the wilds of low returns (yet still charging their fees). Some do a killer business in a specific market and then give back those gains, painfully, over the next few cycles.
Yet the market powers on. The S&P 500 stock index returned 9.2% annually in the 20 years from 1994 through 2013, years which included the massive market bust of 2008 and 2009, according to data compiled by market researcher Dalbar.
How did individual investors do during that time-frame? Terribly, just 2.5% annually. Surely they would love to have those 20 years back and a chance to earn a the market “average” instead.
Consistency is paramount. You money earning 2.5% simply doesn’t grow very fast. For instance, a $10,000 investment in 1994 grew to $16,386 over those two decades.
Comparatively, the same $10,000 turned into $58,127 at the market rate of return in that period. A better return compounds faster, resulting in a higher total gain.
The best part is, a better return can be had at little extra risk. If you are at a point in your life where having a lot of stocks feels like risky, just invest it in a portfolio of stocks, bonds and other investments, such as real estate.
Even if the resulting return is a lower than the straight stock market, it won’t be the awful return you would get trying your luck at stock picking. Thanks to exchange-traded funds (ETFs), you can buy nearly any asset class you need at a greatly reduced cost.
Rebalancing and reinvesting is the key. Keeping yourself invested in a diversified portfolio allows you to enjoy the market upside wherever it happens to appear while taking gains along the way.
The end result is a portfolio that tracks along with the market, capturing as much of the gains as possible for your level of desired risk while greatly reducing the problems of cost, complexity and nerves. Investing nirvana.