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Why These Investments Will Always Win

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They aren't flashy. They aren't going to give you blockbuster returns. And they won't make you popular at cocktail parties. But if you think the Lost Decade has killed index funds, you're wrong. Index investing is alive and well and is still producing returns that put the bulk of actively managed investments to shame.

Not glamorous, but effective
In the brand-new issue of the Fool's Rule Your Retirement newsletter, Motley Fool Money host Chris Hill tracked down Princeton economics professor Burton Malkiel, a longtime proponent of index funds who wrote the investing classic A Random Walk Down Wall Street.

Indexing works great when markets are going up. But during the past 10 years, index funds that track U.S. stocks have gone pretty much nowhere. That poor performance has led many to conclude that in order to have any chance at decent returns, you have to become a stock picker.

Yet surprisingly, Malkiel still stands by the same message he sent his book's readers in 1973. As he sees it, there are strong reasons why index funds will always prove to be the winners in the active vs. passive investing debate:

  • Index funds beat two-thirds of active managers.
  • In any given year, the one-third of managers who do beat index funds typically aren't able to repeat their feat the following year. Lasting outperformance is very rare.
  • Looking for exceptional investors like Warren Buffett is like trying to find a needle in a haystack -- and until you find it, you're likely to do worse than average.

Let's take a closer look at why index funds put up such strong relative performance, even in lousy markets.

Picking the wrong stocks
Recently, fellow Fool Matt Koppenheffer criticized those who believe that stock picking is a dying art. He noted that despite increasing correlations among different markets, there's no reason to think that individual stocks will move in lockstep. And that spells opportunity for astute stock pickers who correctly identify the trends that make some stocks outperform others.

The problem, though, is that most active managers don't do a good job with that kind of analysis. One reason is that the stock market often thwarts stock pickers with counterintuitive moves that look completely irrational at the time.

As an example, go back to the market lows of March 2009. At the time, many analysts had completely written off Ford Motor (NYSE: F  ) , Sirius XM Radio (Nasdaq: SIRI  ) , and Las Vegas Sands (NYSE: LVS  ) , deeming them deathbed stocks that had little chance of recovery. Even as they rebounded sharply off their lows, skeptics dubbed them part of a junk rally that would end in tears. But index funds stubbornly held onto their shares, and the strong returns those stocks earned definitely added to index funds' performance during the rally.

Meanwhile, what many were recommending was to move into defensive stocks to ward off further declines. Wal-Mart (NYSE: WMT  ) , McDonald's (NYSE: MCD  ) , and Family Dollar (NYSE: FDO  ) were among the few companies that did well during the market meltdown in 2008. Yet Wal-Mart stock lost ground in 2009, and McDonald's and Family Dollar managed only single-digit advances. That didn't come close to the S&P 500's 26% gain.

The next frontier
One area where Malkiel has changed his thinking is with international investments, which he sees as more important than ever. Yet even internationally, index funds have done well. For instance, Vanguard's Total International Stock Index (VGTSX) has outperformed four out of five international funds since 2000. Its emerging-market index -- on which the popular Vanguard Emerging Markets Stock ETF (NYSE: VWO  ) is based -- has beaten three-quarters of its competitors in the past five years and two-thirds of them since 1995.

So if you think you have to become a full-time stock picker in order to have a chance at being a successful investor, think again. Index funds may not be the most exciting investments around, but they still do better than most of those who think they can beat the market.

Read more of Chris Hill's interview with Burton Malkiel in the brand-new issue of Rule Your Retirement. You can get full access to the new issue and much more with a free 30-day trial.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Fool contributor Dan Caplinger doesn't always pick the winner, but he's getting better. He owns shares of Vanguard Emerging Markets Stock ETF. Wal-Mart is a Motley Fool Inside Value recommendation. Ford Motor is a Motley Fool Stock Advisor selection. The Fool owns shares of Vanguard Emerging Markets Stock ETF and Wal-Mart. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is a winner you can count on.


Read/Post Comments (1) | Recommend This Article (11)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 07, 2010, at 8:12 PM, easyavenue wrote:

    DC -

    You compared the offense of the market index on the rebound against the offense of "defensive" stocks. How is that fair?

    If you have to manipulate your statistics to make your point, then of what value is the point made?

    EA

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Dan Caplinger
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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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