Why Index Investing Will Not Work for the Next Decade

Includes: DIA, QQQ, SPY
by: Mark Riddix

I know that everyone loves index funds. They have low fees and allow you to passively invest and get the average return of the market. I cannot argue with that. If you are an investing novice and need exposure to the market, then I agree that you should grab an index fund. If, however, you have a little investing experience, I believe that you would be better served by becoming a more active investor. Let me tell you why.

I have been saying that index funds are not going to be great growth investments in the future for some time now. Take a look at the 10-year performance of the S&P 500 index over the past 10 years. The S&P 500 is down nearly 70 points for a total loss of -5.69 percent. This is even with the market bounce-back of the past two years. Index investing did not work over the past decade.

While I am not a huge fan of most mutual funds, I can name a good number of them that actually had a positive performance over the past decade. They aren’t even the hottest funds in industries or niche funds that did well; these are boring solid funds. While the market may have been down over the past decade, the mutual funds that I invested in actually were up. One of the better ones returned 52% over the past 10 years.

The secret is that there is no secret. I keep it simple. I have a balanced fund, growth fund, and a value fund that I absolutely love. All three of them beat the S&P 500 and I did not follow a hot fund manager. The common theme among them is that they all have low fees, great management, and pay solid dividends. The growth has been great.

My Issue With Index Funds

Forget about the double digit growth of the market in previous decades. Every investment adviser I know used to love to trumpet that the average return of the stock market was 10 percent. This was true historically, but it is not going to be the case going forward. The new normal is a low-growth economic environment domestically. Most U.S. large caps are not the growth plays that they once were.

The Standard & Poor’s 500-stock index gives the greatest weight to stocks with the largest market caps. This means that stocks with the biggest run-ups have the biggest effect on the index. Therefore, most index funds are weighted toward stocks that are more likely to be overvalued. Personally, I would rather own a larger percentage of a quality company whose stock underperformed the previous year than a company whose stock was on fire last year.

Individual Stock Investors

I think stock investors can do even better than fund investors. Case in point: It didn’t take a ton of foresight to know that General Electric (NYSE:GE) was a good buy when it was trading at $10 a share. Did anyone really think that Buffett would invest billions of dollars in a company headed for bankruptcy? How about Cheesecake Factory (NASDAQ:CAKE) when it was at $5? Or Chicago Bridge & Iron (NYSE:CBI) when it was trading at $19? That stock has been a nice 65% gain for my portfolio over the past year. I will admit Bank of America (NYSE:BAC) was a major risk when it was in the single digits.

You don’t have to bat 1.000 to be a great stock investor. All you need to do is pick one outperformer and that will make your whole portfolio look good. My returns were much higher buying General Electric, Bank of America, Wells Fargo (NYSE:WFC), Cheesecake Factory, and Alcoa (NYSE:AA) than they would have been buying any index fund. I didn’t know where the market bottom was, but I knew that some stocks were selling way too cheaply.

It’s tougher to find cheap values now, but there are some available. I still think that the best investment opportunities are in small caps, REITs, and financials. Ask me if I think that a self-managed portfolio comprised of just a few small caps and value stocks will outperform the S&P 500 as a whole, and I will say "yes" every time.

Final Thoughts

Index funds are perfect for busy investors who do not have time to manage their portfolios. If you have the time and do a little homework, you can beat the returns of an index fund.

To further illustrate my point, in January I am going to create a portfolio of five stocks and judge its performance against the S&P 500 index on a long-term basis.