Indexing: Myths and Realities

Data Credit: Se Hoon Park

"The stock market on average earns 10-11% a year."

This statement is considered common knowledge by the investment community and financial publications alike, and is particularly important to consider when thinking about following a simple Indexing strategy. Indexing revolves around the idea that for a variety of technical reasons, it is impossible to beat the market as a whole over the long term. Instead of trying to pick a few gems out of a haystack (with the gems being high performing stocks and the haystack the market) one should just own the entire stack (Analogy Credit: Benjamin Graham)! That way you are guaranteed to reap all the gains (and losses) of the market, year after year.  

From this angle, 10% looks like a pretty good return, especially when you consider the effects of compounding this growth year over year for decades and constantly contributing more capital to the plan as time goes on. But, how true is this "truism"?

We looked at returns of various indexed over multiple time frames to find out, as follows:

Index Time Period Return
Dow Jones Industrial  1932-2010 6.89%
Dow Jones Industrial  1928-1994 3.92%
S&P500  1932-2010 6.81%
S&P500  1932-1998 8.04%
NASDAQ 1971-2010 8.19%
Wilshire 5000 Full Cap  1970-2010 7.01%

We tried manipulating this data as much as possible to the market's favor in order to hit that 10% mark. This included starting from 1932 when possible (meaning buying in at the low point of the Great Depression, a perfect entry) and avoiding the tech bubble of the late 1990s. Yet, we could never get 10%, and at times even ran a return as low as 4% over the period of analysis.

These new numbers look a lot less tempting than the 10% "common knowledge" figure, especially when you take into account inflation, fees, and taxes. What this proves is the huge fallacy of Indexing that is often ignored: timing is everything. If you begin a Indexing strategy at the right time, you can look forward to decent returns over the long term. However, an ill-timed entrance or exit (like those who planned to start living off retirement savings in 2008) can prove disastrous.

Overall, I still feel Indexing is the best strategy for those who do have the time, inclination, and discipline to stick to a long term, value focused investment approach. Very rarely do Mutual Fund and Financial Advisors ever beat the market, so why spend more in fees and take on more risk when you can simply match the market?

However, for those with the time and inclination (which yield the ability to gain the knowledge of investing for value over the long term) and discipline to withstand the daily ups and downs of the market, Indexing is definitely a way to sell yourself short.