248
larger share of your investment flows directly into your purchase of stock.
An equity mutual fund indexed to a broad stock market indicator such as the S&P 500
for the United States will earn approximately the average
stock market return for its
shareholders
(?)
. The United States is not alone in having Index Funds. Most large economies
have one or more such funds and more are being opened regularly. It is possible to purchase
Index Funds for individual developing countries including those in Eastern Europe (iShares
MSCI China ETF, Franklin India Index Fund, Expat Czech PX UCITS ETF or VanEck Vectors
Russia ETF.). You can also buy regional funds that track shares in a particular set of countries.
(112)
What is so great about the average return? As noted earlier, historically the stock market
has yielded an average real rate of return of about 7 percent when held for long periods. That
means that the
real value
(?)
, the value adjusted for inflation, of your stock holdings doubles
approximately every ten years. That’s not bad. Even more important, the average rate of return
yielded by a broad index fund beats the return of almost all managed mutual funds when
comparisons are made over periods of time such as a decade. This is not surprising because, as
the random walk theory indicates, not even the experts will be able to forecast consistently the
future direction of individual stock prices with any degree of accuracy.
Over
the typical ten-year period, the S&P 500 has yielded a higher return than 85
percent of the actively managed funds. Studies of European active vs. passive managers
support these findings.
(113)
Over twenty-year periods, mutual funds indexed to the S&P 500
have generally outperformed about 98 percent of the actively managed funds.
(114)
Thus the
odds are very low, about one in fifty, that you or anyone else will be able to select an actively
managed fund that will do better than the market average
over the long run.
Just because a managed mutual fund does well for a few years or even a decade, it does
not follow that it will do well in the future. For example, the top twenty managed United States
equity funds during the 1980s outperformed the S&P 500 Index by 3.9 percentage points per
year over the decade. But if investors entering the market in 1990 thought they would beat the
market by choosing the “hot” funds of the 1980s, they would have been disappointed. The top
twenty funds of the 1980s underperformed the S&P 500 Index by 1.2 percentage points per
year during the 1990s. Similarly, the average return of the top twenty managed equity funds
from 1990 to 1999 outperformed the S&P 500 Index by 3.1
percentage points per year, but
249
from 2000 to 2009 those same funds underperformed the S&P 500 Index by 1.3 percentage
points per year.
(115)
The “hot” funds during the stock market bubble of the late 1990s were an even more
misleading investment indicator. Over the two-year period 1998–1999 the top-performing
managed fund was Van Wagoner Emerging Growth, with a 105.52
percent average annual
return. But over the two-year period 2000–2001, this fund experienced an average annual
return of
minus 43.54 percent, one of the lowest during this period.
(116)
These examples actually understate the advantage of a mutual fund indexed to the S&P
500 compared to a managed equity fund because of the survivorship bias. The S&P 500 index
is highly unlikely to go out of business, but over the time period relevant to saving for
retirement, a managed fund is quite likely to shut down. A mutual fund can disappear for two
reasons, both related to poor performance. It may be shut down with the remaining value of the
fund
distributed to its owners, or it may be merged into another managed fund with a better
record. Although there are thousands of managed mutual funds today, in 1970 there were only
358 in the United States. Burton Malkiel followed those funds through 2013. During these 43
years, 274 funds—over 75 percent of the total—ceased to exist. Out of the remaining 84, only
4 had outperformed the S&P 500 index by 2 percentage points or more on an annual basis.
(117)
The stock market has historically yielded higher returns than other major investment
categories, and index funds make it possible for the ordinary investor to earn these returns
without worrying about trying to pick either individual stocks or a specific mutual fund. A
study that compared 118 years of returns on stocks and bonds from 21 countries that have data
going back that far showed that stock market returns outperformed
bond returns over the
period for every country.
(118)
They even returned an average of 3–6% annually, despite
including the periods of the two World Wars.
Of course, there will be ups and downs and even some fairly lengthy periods of
declining stock prices. Therefore, many investors will want to reduce equities as a percentage
of their asset holdings as they approach retirement (see the following element). But based on a
lengthy history of stock market performance, the long-term yield derived from a broad index
of the stock market can be expected to exceed that of any other alternative, including managed
equity funds.
(119)
250
As Exhibit 25
illustrates, when held over a lengthy time period, a diverse holding of
stocks has historically yielded both a high and relatively stable rate of return. Data for the
highest and lowest average annual real rate of return (the return adjusted for inflation) derived
from broad stock market investments for periods of varying length between the years 1871 and
2014 are shown here. The exhibit assumes that the investor paid a fixed amount annually into a
mutual fund that mirrored the S&P 500 Index.
(120)
Clearly, huge
swings are possible when
stocks are held for only a short time period. During the 1871–2014 period, the single-year
returns of the S&P 500 ranged from 47.2 percent to minus 40.8 percent. Even over a five-year
period, the compound annual returns ranged from 29.8 percent to minus 16.7 percent.
