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As I understand it, stocked-based index fund have been a reliable long term investment option in the last X years. Specifically, during "most" 10-year intervals in the examined history, the yield on them out-performed most other investment options (8.5% yearly according to this).

According to this, my investment strategy is simply putting most of my money in different stock-based index funds. What are the odds that this is in fact an instance of the Hasty Generalization Fallacy? In other words, what are "the odds" that the yields on stock-based index funds will drop significantly in the next few dozens of years? (If anyone can presume to make such predictions)

(The Generalization Fallacy is a false logical tool, through which we can deduce that we'll live forever, simply because we have been living in the last X years - it's a misuse of the mathematical induction principle)

Edit - I'd like to clarify, that I'm not comparing index funds to individual stocks, but rather to other investment channels such as bonds or money market.

  • It's an interesting thought, but not a good question for here since it would just generate a bunch of discussion (and not answers). No one can actually tell you what the likely future is (besides being similar to the past). – Michael Pryor Mar 3 '11 at 16:45
  • @Michael - I disagree that "No one can...". People do serious academic research on this. I'm not expecting a crystal ball, just some well though arguments. – ripper234 Mar 3 '11 at 17:06
  • reopened. waiting for a decent answer ;) – Michael Pryor Mar 3 '11 at 18:08
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    I am interested in an answer, as this is my strategy. – MrChrister Mar 3 '11 at 21:13
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When you are putting your money in an index fund, you are not betting your performance against other asset classes but rather against competing investments withing the SAME asset class. The index fund always wins due to two factors: diversity, and lower cost. The lower cost attribute is essentially where you get your performance edge over the longer run. That is why if you look at the universe of mutual funds (where you get your diversification), very few will have beaten the index, assuming they have survived.

-Ralph Winters

  • You are discussing a stock index fund vs a stock mutual fund. It was my guess that he wasn't simply discussing stocks, but all forms of investment. That is why this is a question without an answer, as no one knows. We can "guess" that stocks have continued to perform, but we could also enter a 30 year period where US stocks fall / are stagnant. – Ceberon Mar 4 '11 at 18:10
  • Even if other asset classes are included, the probability is high that an index fund based on that asset class would outperform a mix of underlying instruments based on the asset base. There are many index funds which parallel the major indices (stocks, bonds. real estate, commodities etc.) – Ralph Winters Mar 4 '11 at 18:48
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For index funds to be a poor investment, they would have to perform worse than your alternative investments. In this case, we'll assume the alternative to be the individual stocks. Obviously, it must be possible to pick just the winning stocks and avoid the losing stocks, raising your rate of return... however, several studies have shown that individuals are horrible at picking winners. We let our emotions, are biases, and are suppositions get in the way. You could literally throw a dart, but then you either win big or lose big. Picking the fund evens that out for you, so you don't win or lose big, but just get a consistently boring (yet consistently good) return.

If you have a lot of time to put into the research, and are confident in your ability to pick winning stocks, then you can do better than the index funds. Otherwise, sticking with the index fund is probably a smart choice.

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    This is stocks vs stocks. What about commodities, foreign currencies, real estate, etc? There are many options other than stocks for investments. – Ceberon Mar 4 '11 at 18:11
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    If you have an investment that fails to meet your goals by losing money, then it's a poor investment. It doesn't matter whether other investments were equally poor. The benchmark that matters is reaching your goals, not beating the market. A balanced/diversified portfolio is much more predictable when it comes to reaching goals. (I agree that index funds are more predictable than individual stocks, but the even more important issue is that 100% stocks is not a good idea, in my opinion.) – Havoc P May 13 '11 at 18:07
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Stock index funds are likely, but not certainly, to be a good long-term investment.

In countries other than the USA, there have been 30+ year periods where stocks either underperformed compared to bonds, or even lost value in absolute terms. This suggests that it may be an overgeneralization to assume that they always do well in the long term. Furthermore, it may suggest that they are persistently overvalued for the risk, and perhaps due for a long-term correction. (If everybody assumes they're safe, the equity risk premium is likely to be eaten up.)

Putting all of your money into them would, for most people, be taking an unnecessary risk. You should cover some other asset classes too. If stocks do very well, a portfolio with some allocation to more stable assets will still do fairly well. If they crash, a portfolio with less risky assets will have a better chance of being at least adequate.

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I think you need a diversified portfolio, and index funds can be a part of that. Make sure that you understand the composition of your funds and that they are in fact invested in different investments.

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The idea behind investing in index funds is that you will not under perform the market but also at the same time not over perform against the market either. It is meant for those (majority of the investing population) who do not or cannot invest more time in actively researching different investment options. So even considering for a moment that the yields on the index funds will drop significantly in the future, since the fund is supposed to be replication of the whole market itself, the market too can be assumed to be giving significantly lower future yields. In my opinion the question that you ask is confusing/contradictory because, its like pegging the fund performance to an avg and then asking if it will be higher or lower in the future. But rather its always going to be exactly the average, even if the absolute yields turn higher or lower

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A diversified portfolio (such as a 60% stocks / 40% bonds balanced fund) is much more predictable and reliable than an all-stocks portfolio, and the returns are perfectly adequate. The extra returns on 100% stocks vs. 60% are 1.2% per year (historically) according to https://personal.vanguard.com/us/insights/saving-investing/model-portfolio-allocations

To get those average higher stock returns, you need to be thinking 20-30 years (even 10 years is too short-term). Over the 20-30 years, you must never panic and go to cash, or you will destroy the higher returns. You must never get discouraged and stop saving, or you will destroy the higher returns. You have to avoid the panic and discouragement despite the likelihood that some 10-year period in your 20-30 years the stock market will go nowhere. You also must never have an emergency or other reason to withdraw money early.

If you look at "dry periods" in stocks, like 2000 to 2011, a 60/40 portfolio made significant money and stocks went nowhere. A diversified portfolio means that price volatility makes you money (due to rebalancing) while a 100% stocks portfolio means that price volatility is just a lot of stress with no benefit.

It's somewhat possible, probably, to predict dry periods in stocks; if I remember the statistics, about 50% of the variability in the market price 10 years out can be explained by normalized market valuation (normalized = adjusted for business cycle and abnormal profit margins). Some funds such as http://hussmanfunds.com/ are completely based on this, though a lot of money managers consider it. With a balanced portfolio and rebalancing, though, you don't have to worry about it very much.

In my view, the proper goal is not to beat the market, nor match the market, nor is it to earn the absolute highest possible returns. Instead, the goal is to have the highest chance of financing your non-financial goals (such as retirement, or buying a house). To maximize your chances of supporting your life goals with your financial decisions, predictability is more important than maximized returns. Your results are primarily determined by your savings rate - which realistic investment returns will never compensate for if it's too low.

You can certainly make a 40-year projection in which 1.2% difference in returns makes a big difference. But you have to remember that a projection in which value steadily and predictably compounds is not the same as real life, where you could have emergency or emotional factors, where the market will move erratically and might have a big plunge at just the wrong time (end of the 40 years), and so on. If your plan "relies" on the extra 1.2% returns then it's not a reasonable plan anyhow, in my opinion, since you can't count on them. So why suffer the stress and extra risk created by an all-stocks portfolio?

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