So take heart. When pessimism prevails, bargains are more likely than rip-offs. Pessimism isn't a sign we should stop investing in stocks. Or that we should abandon index funds.
Index funds are the only way the average investor can avoid the recommendations of the investment/retirement complex and their debilitating expenses. While low tax rates on dividends and capital gains make the tax efficiency of index funds less meaningful, actively managed (and actively sold) funds still have higher portfolio turnover averaging over 100 percent while the largest index funds average 2 percent. That extra 98 percent is an invisible layer of expense.
Yes, managed funds did better than index funds in the bear market. The sales force, ignoring more than 30 years of results and research, declares this to be the end of indexing. Hogwash. Managed funds have a portion of their assets in cash. Index funds are fully invested. Result: index funds rise more in bull markets and fall more in bear markets.
At the end of July, the average large cap blend managed fund had returned 9.17 percent over the preceding 12 months. The Vanguard 500 Index fund returned 11.02 percent. Vanguard Total Stock Market Index fund returned 10.66 percent. The 500 Index fund bested the average managed fund over the last 5, 10, and 15 years--- but trailed by 0.33 percent over the last 3 years.
The Total Market Index fund beat the average managed fund over all time periods. Over the last 10 years it returned 13.71 percent annually. The average managed fund returned 11.50 percent, a massive 2.21 percent difference.
That, of course, only measures comparable large cap blend funds. But the major index funds also did better than managed funds in other fund categories: large cap, mid-cap, and small cap growth. They trailed against large, mid, and small cap value funds and the mid and small cap blend funds.
Does this mean index funds are doomed?
Not likely. Large cap stocks represent about 80 percent of all market capitalization. Mid cap and small cap stocks represent about 20 percent. Take the averages, make the investments proportional to capital value and a combined 80/20 large/mid cap managed portfolio returns 12.69 percent. That's still behind the 13.00 percent of the Vanguard 500 index or the 13.71 percent of the Vanguard Total Stock Market fund.
Bottom line: There is a chance that we can improve performance by seeking professional help. But the chance is much reduced by a dismal reality. The number of true investment professionals is seriously diluted by massive numbers of ill equipped salespeople. Who do you think John Q. Public is most likely to meet?
Indexing core assets remains our best defense.
Will investing in stocks produce disappointing returns in the future?
Morningstar's analyst observes that the historical 10 percent return was boosted by an average dividend yield of 4.1 percent. The current yield is only 1.9 percent. All other things equal (P/E ratio, capital gains return), we should expect a future return that is 2.2 percent lower.
That would take the future return on common stocks down to about 8 percent. Worse, P/E ratios are high and could "regress toward the mean." That would reduce future returns still further.
But Vanguard founder John Bogle made the same argument--- in 1991. He forecast the 90's would probably bring lower returns than the 80's. His idea was sound--- but high valuations can persist for long periods of time. This is 2004.
The important question isn't whether future stock returns will be disappointing. It is how will they compare to other investments?
A likely return of 8 percent looks very good compared to earning 1 percent on cash. It also looks good compared to earning 4 or 5 percent on high quality bonds.
Bottom line: This is a good time to keep on keeping on. We need to have faith that we, collectively, create more value than we destroy. We need to remember that the stock market is only a shabby sideshow to the engine of human creativity.
On the web:
July 20, 2004: Motley Fool--- The Case Against Index Funds (Registration required)
August 1, 2004: Scott Burns: Thinking Financial Blasphemy
August 11, 2004: Morningstar: Stock Market Returns Are Likely to Disappoint
Sunday, July 7, 1991: Forecasting Total Returns for the Nineties: TBA (910707SD)
Tuesday: Searching For Winners that Don't Lose
This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational puposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
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