Wednesday, December 13, 2017

Are Index Funds Safe?

In the years following 2008, any time I recommended a mutual fund, portfolio, managed account, or any other investment, clients would almost always ask me: "How did this do in '08?"

What people were really asking was "is this going to protect me from the downside next time the market corrects"?

This often lead to discussions about bond funds, which at the time showed steady 10-year track records like the blue line in this graph.

"See, look how smooth the growth has been compared to stocks (yellow line is the S&P500)". A few years ago, the 10-year return for bonds even looked better than stocks. Lots of money poured into bond funds from cash that investors had pulled out of stocks but were too afraid to get full back into stocks.

Shift to Index Funds

As stocks have continued to set new records, including now the first year ever of 12 winning months, a tsunami of cash has been piling into index funds driven in part by charts like this one:

"Stocks are the best long term investment, but why waste money on actively managed funds when the mostly underperform the index?" Sound familiar?

A lot of this capital has come actively managed stock funds but also from cash and bond funds. If money is going into Index Funds from cash and bonds, many of these investors previously cashed out of stocks.

During the 2008 financial crisis, I met too many people who thought that actively managed funds "should have seen it coming" or "should have gone to cash". It came as a surprise to many investors that their mutual funds prospectus prohibits market timing. Now those same investors who poured cash into bonds when they were still afraid of stocks have been rushing to index stock funds as stock performance continues to enhance feelings of FOMO.

Personally, I doubt their original unrealistic expectations have changed. The market has gone up for so long there hasn't been the need to blame anyone for losses, and there are many who have pitched index funds as "safe". Sure, they're safe in that they are diversified, but when the average investor asks if something is "safe", they aren't thinking about the difference between systematic and unsystematic risk. They are asking whether they'll ever lose money. They'll tell you they know the risks of investing in the market, but when we next see a >10% drawdown that will all be forgotten.

Are Index Funds Safe?

Index funds are no "safer" than the actively managed mutual funds they've been replacing in investor portfolios. The only things they save you from are higher fees and the risk of underperforming the market. I'm all about being a DIY investor, but it is important to have realistic expectations. When the market tanks, you'll be just as exposed as anyone else. I'm ok with that risk, but the average investor attempting to time the market may be disappointed.

I'm very curious to see what happens to fund flows after the next market selloff. Will those new to indexing strategies truly stick with it? As much as has been said about the change in investor preference and behavior, I'm still skeptical.

There is strength in numbers, and following the herd mentality sometimes just feels right. Sitting in cash when everyone else is losing feels great at that moment. That still doesn't mean it's the right move long term.


  1. Yes people tend to forget that index funds don't protect you from risk of losing in a market downturn. I don't know how I'll fair in a down year yet I'm only 19 and started at 18. I'm 98% stock and plan on keeping it that way until I hit my "imaginary number" i don't even know the number yet. Good thing I've got to speak to so many younger/older investors and FIRE bloggers to get a sense. I don't think I'll panic. I don't care too much about losing cause I have 30-40 year horizon before I'm even close to being done.

  2. Way to go, starting so young! Being plugged into a community of folks that can help talk you off the ledge during a downturn is important. That's often the job of a financial advisor but so many in the FIRE community are DIY investors that they act as their own support group instead.