““By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals.” -Warren Buffett

Time Frame
Year to date the market is down around 9%; not since July 2006 has a month ended with the S&P 500 trading below 1300. Does that matter? No. An investment’s success (and failure) should be measured over time frames longer than 17 months. How long? That is topic I’ll tackle later. How about a 10 years? Certainly a decade is a sufficiently long enough time frame to determine an investment’s success.If we wisely invested in a market tracking low-cost index fund ten years ago, how much would our purchasing power have increased?

S&P 500
To test our 10 year performance let us explore the performance of the Standard & Poor’s 500. This index represents the largest 500 companies in the United States with each company’s relative weight based on market capitalization (think market price times the number of shares outstanding). Many investors simply refer to the the S&P500 as “The Market.” So this index’s job is to provide us with our fair share of the stock market’s return.

Performance
What has the largest 500 companies in the USA returned to their investors over the last 10 years? 3% (and yes that includes the dividends)! What!?? A lousy 3% including dividends. Let’s not even talk inflation.

Three Alternatives to Index Funds: Mutual Funds, No Stocks Market, Do-It-Yourself
#1 You might be thinking to yourself “Certainly we could have done better in mutual funds.” That depends on a couple of things. First, what expertize do we have in selecting mutual fund managers? And what does that fund manager’s hard work, research, and market beating performance cost?We might have beat the market if we properly selected one of the less than 1 out of every 100 mutual funds that successfully beats the market over longer time frames. That means that for every 1 that does beat the market 99 don’t. For that manager’s exceptional performance we’d probably pay at least 1.5% annually. That means that our manager needs to earn 4.5% every year that the Market earns 3% just to match the returns of the market. Otherwise we would have been better off just buying the index fund.Ultimately we need to be 100% confidant in our ability to select fund managers that can constantly beat the market in excess of their management fee. With probabilities like that you’d be well advised to stick with the index.

#2 At this point it is easy to get frustrated, run to your nearest bank and get yourself a certificate of deposit yielding a guaranteed 4% and forget the stock market all together. That would be a serious long-term mistake. If you are unwilling (or unable) to explore alternative #3, investing in an Index Fund is a very viable option (much more attractive than a CD). Don’t give up.

#3 Fortunately, there is a better alternative than Wall Street’s mutual funds, index funds, ETFs, hedge funds, and whateverelse funds! Using a couple of tools and a few mental models we can successfully invest in businesses (stocks), earn an acceptable (if not damn-right fantastic) rate of return, AND sleep well at night. More on this in my next post.

And alternative #3 is what this blog is all about!