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I have often heard the phrase "nobody beats the index" which made me wonder why so many people, that invest for the long term (say 20-25 years), diversify their positions so much? Why wouldn't somebody invest simply in one or two index trackers (say S&P 500 and FTSE Euro 1000) listed in their own currency?

I have seen numerous asset management companies that invest in a broad spectrum of different funds and ETF's but fail to beat the S&P 500 / FTSE Euro 1000. Is there a reason for this? Is a period of 25 years not long enough to "guarantee" a certain growth?

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    Well, what you're seeing is that net of fees, most money mangers don't beat the index. The issue is the outsized fees more than it's performance, on average.
    – quid
    Jan 11, 2017 at 20:48
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    Plenty of people "beat the index" cosistently. There are many years that an index can go down 10% or more, and I know people who have made 20%+ during those years, and made similar returns when the index goes up by 10%, by the way none of them were asset management companies or fund managers.
    – user9822
    Jan 11, 2017 at 21:43
  • Because most managers are index huggers (long only funds) or are not running enough vol to have a chance of beating the index. But there are consistently good managers around. It's not just about luck.
    – SMeznaric
    Jan 12, 2017 at 13:05
  • To add a contrarian view to the above comments: No actively managed fund has beaten the indices over a long period of time, but over shorter periods, actively managed funds have beaten the indices quite often, sometimes quite spectacularly, and sometimes even for many years in a row. Examples from the past include Fidelity Magellan and Legg Mason Value Trust. Part of Magellan's problem was that so much money flowed into it that it essentially became an index fund: most funds have policies prohibiting investing more than x% of assets in one company, or buying more than y% of a company's shares.
    – Dilip Sarwate
    Jan 13, 2017 at 15:03

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Even something as an S&P500 index is biased towards a particular investment distribution. For instance, in the case of owning SPY/S&P500, you are heavily betting on large-caps whose primary earnings are in the United States and in US dollars. One could argue that political/economic conditions may shift over time making start-ups/small-caps more favorable from a return-perspective (in fact, there is significant research indicating a persistent small-cap premium). Similarly, many currently argue that US stocks are presently over-valued compared to other assets and other developed/emerging market equities (as was certainly the case in the early-2000s). The US dollar is the strongest it has ever been in the last 10+ years. A return to previous values would lead to out-performance by assets abroad.

From a broad asset allocation perspective, one may be able to find other asset classes that are loosely correlated with the major indexes but can also deliver longer-term out-performance based on their current valuation. Additionally, investing in non-correlated/negative-correlated assets minimizes portfolio volatility during turbulent times, allowing one to stay the course and not liquidate portfolio during potentially favorable conditions.

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Certain sectors can beat the index over the short run. A person can move in and out of that as they choose. And here, by short term, the rally in a sector can lasts for years.

Also one can invest in hand picked stocks that can easily beat the index.

Diversification is another reason. Experts disagree on the amount, but if one was living off of investments at least some portion of assets should be in bonds/cash to avoid market fluctuations. Some feel that a decent portion of assets should be in bonds during the accumulation phase as well.

Given a smallish portfolio, just being index funds is fine. Once it grows sufficiently large there should be diversification into international, and domestic; small, large, and medium size companies; and, growth and value companies.

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  • How much index funds would you suggest for a small portfolio?
    – Martijn
    Jan 11, 2017 at 20:52
  • For the US of A: S&P 500 from either Vanguard or Fidelity. To me the edge goes to Fidelity because the site is easier to use.
    – Pete B.
    Jan 11, 2017 at 21:04
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    For a small portfolio, where small in fact includes many or most of us here,, I'd go (and have gone) with 100% low-fee index funds, mixing funds to get my desired diversification across kinds of investments to match my preferred level of risk/volatility.
    – keshlam
    Jan 11, 2017 at 21:53
  • There are reputable investment banks other than the two @peteb mentioned. I'm using one of them. Do your homework before accepting anyone's recommendations.
    – keshlam
    Jan 11, 2017 at 21:55
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    And for what it's worth, I'm considering "small" to go up to several millions at least -- anything not large enough to justify a professional portfolio manager.
    – keshlam
    Jan 13, 2017 at 5:26
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The phrase you quote is misleading, as there is no such thing as "the" index. There are many indexes. So diversifying in the sense of buying funds tracking multiple indexes is a reasonable practice. In the same way that buying an S&P 500 index fund lets you partake in the aggregate growth of the 500 largest US companies without exposing you to undue risk in any one of them, buying several indexes that are not highly correlated (e.g., a US large cap index, a small cap index, an emerging markets index) can allow you to gain from the growth of any of the sectors without putting all your eggs in one basket. (There are also funds that track very broad indexes, like the Vanguard Total World Stock Index Fund.)

That said, you will still find individuals and asset managers that "diversify" in a way that is on average inferior to buying into an index (or some set of indexes). Individuals usually do this because they don't know any better. Asset managers do it because they make money off the individuals who don't know any better (by charging them management fees).

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