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Over the past ten years or so, many investors have been convinced that index funds are the way to go because they outperform 95% of all managed funds. I see three major problems here:

#1 - What does “outperform” mean? Down “only” 25% vs. a 30% drop in an actively managed fund in a bad year?

#2 - The latest prospectus for Vanguard S&P 500 Index Fund lists annual returns for the past 10 years as follows:

1998 28.62%
1999 21.07%
2000 (-9.06%)
2001 (-12.02%)
2002 (-22.15%)
2003 28.5%
2004 10.74%
2005 4.77%
2006 15.64%
2007 5.39%

Assuming you invested $10,000 at the height of the Internet euphoria in early 1999, you would have had $12,107 at the end of 1999 according to the table. But then we went into a bear market in 2000 - 2002 and assuming you stayed fully invested “for the long haul” according to your financial plan, your original $10,000 would have shrunk to $7,541.

Question: When would you have recouped your original investment? If your answer is: 2003 (21.07% - 9.06% - 12.02% - 22.15% + 28.5% = 6.37), you are wrong. You would have had to wait until the end of 2004. Why? Because you don’t add up pluses and minuses when calculating investment returns.

To illustrate: if you invest $10,000 and lose 50%, you are down to $5,000. To recoup your loss, you now need to gain 100%. To recoup a (-9.06%) loss you need to gain 9.96%, a (-12.02%) loss - you need to gain 13.66%, and a (-22.15%) loss - you need to gain 28.45%. That’s why in real life you would have had to wait till the end of 2004 to get back above $10,000.

In hindsight, it’s not that terrible - waiting six years to break even. But only in hindsight and in theory. There is a huge lost opportunity cost. Besides, people tend to forget about their long term plans and bail out when they have a loss and the pain becomes unbearable. Unfortunately, most people tend to bail out at the exact bottom and are too burnt to get right back in when the market finally turns, repeatedly selling low and buying high (in that order).

One can make a case for long term investing by adding in the 2004 - 2007 gains. But, then again, if you subtract the 2008 loss… Which brings us to the third point:

#3 - Every market advance is powered by new leaders. For example, 2003 saw strong advances in select technology, along with home builders and retailers; in 2004 oils and metals began their climb; 2006 was dominated by capital goods, while 2008 saw dramatic advances in agriculture stocks. Each of these advances produced multiple zoomers that gained 30 - 50% or more in a relatively short time. If you bought fresh breakouts in new sectors at the beginning of each new advance and sold them at the beginning of each correction, you would have locked in the bulk of those gains and compounded them. In the indices, these powerful advances are watered down by declines in other sectors. If you invest in the averages, the best you can do is capture those average returns, and in a bad year like 2008 you risk giving it all back and more.

Slav Fedorov is a full time stock trader and founder and managing member of TradingZoom, LLC - a provider of timely stock picks in small caps based on proprietary selection methods. http://www.tradingzoom.com/

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