Index mutual funds that simply track their stock market benchmark
have an important thing going for them:
They Never Have a Bad Year! At
least not relative to the stock market they are tracking. Yes, they can fall and will when the stock
market falls. But the big difference
between index funds and actively-managed funds is that every year a big number
of actively-managed portfolios will have a bad year compared to the market they
track. And it’s very hard to tell in advance
which of the funds will be the stinkers.
Since all stock investors make up the whole market, some investors have
to have a bad year in order for others to have a good year. And when you subtract out the management fee that
active managers extract from their funds, more active managers trail the market
than beat it, as history has shown.
What’s the effect of one bad year?
In Kiplinger’s Personal Finance (July 2017), columnist Kathy Kristof
reveals that her results were average over most years but had just one bad year
doing 20% worse than the market. That
one bad year caused her 5.5-year return to trail her index fund benchmark by 31
percentage points because of compounding.
I wonder if she will have to work an extra year before retirement to
make up for that or perhaps drive a Toyota instead of a Lexus. For your purposes, consider whether an index-fund
portfolio will let you sleep better at night knowing that your investments have
only stock-market risk to worry about and not the added risk that a fund manager
might make the wrong bets this year.
Larry Pike, CFA
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