Index Funds Don’t Work in Bear Markets

This is a guest post from Rob Bennett. In the Carnival of Personal Finance we recently hosted, we included a submission from Mike Piper at The Oblivious Investor that Rob disagreed with. He asked if he could rebut it, and because he largely met the Control Your Cash guest post criteria, we said yes. We then gave Mike the opportunity to rebut the rebuttal. He politely declined, so we’ll consider today’s post to be the terminus of this issue. (So if you want to leave a comment today, you’d better make it count.)

As for Rob, his claim to fame is developing “the first retirement calculator that contains an adjustment for the valuation level that applies on the day the retirement begins.” His bio is here.

Some people LOVE a bear market

Mike Piper at The Oblivious Investor blog argues in a recent article that Index Funds Work in Bull and Bear Markets. The argument is that index funds earn the market return and that, if you try to pick good stocks, you might pick wrong and end up earning less than the market return. So index funds are your best choice.


I don’t buy it.
If stock investing were not so intensely emotional an endeavor, we would all be able to spot the flaw in this logic chain in 10 seconds.


Stocks do not do well in bear markets! Index funds are stocks! You do not want to be invested in index funds in bear markets! D’oh!


I have a stock valuation calculator (“The Stock-Return Predictor”) at my web site that performs a regression analysis on the historical stock-return data to reveal the most likely 10-year return for stocks starting from any of the possible starting-point valuation levels. It shows that the most likely annualized 10-year return in 2000 was -1%. Treasury Inflation-Protection Securities (TIPS) were at the time paying a government-guaranteed return of 4% real.


That’s a differential of 5 full percentage points of return per year for 10 years running. The investor who chose stocks over TIPS in 2000 was setting himself up to over the course of 10 years lose 50 percent of his accumulated savings of a lifetime. The investor with a $100,000 portfolio was likely to end up $50,000 poorer at the end of 10 years. The investor with a $500,000 portfolio was likely to end up $250,000 poorer at the end of 10 years. The investor with a $1 million portfolio was likely to end up $500,000 poorer at the end of 10 years.


Those who appreciate the power of the compounding returns phenomenon will understand why those numbers are only the beginning of the story, not the end of it. Investors who won for themselves a $50,000 differential or a $250,000 differential or a $500,000 differential will be seeing the size of those differentials grow and grow over the course of however many years they will be continuing their walk through the valley of tears.


It’s not just crazy Rob Bennett who says that valuations affect long-term returns. Yale Economics Professor Robert Shiller showed this in research published in 1981 and explained why it works this way in his widely praised and best-selling book Irrational Exuberance. There is now 30 years of academic research backing up Shiller’s findings. The latest study making the point is a study by Wade Pfau, Associate Professor of Economics at the National Graduate Institute for Policy Studies in Tokyo. You’ll find that one here.


Pfau’s study states: “On a risk-adjusted basis, market-timing strategies provide comparable returns as a 100% stocks buy-and-hold strategy but with substantially less risk. Meanwhile, market timing provides comparable risks and the same average asset allocation as a 50/50 fixed allocation strategy, but with much higher returns…. Valuation-based market timing with P/E10 has the potential to improve risk-adjusted returns for conservative long-term investors.”


So we do not need to be invested in stocks via index funds or through any other means during bear markets!


Long bear markets are not random events. They only show up following runaway bull markets. And they always show up following runaway bull markets.


Pay attention to the price of the stocks you buy, going with a lower stock allocation when stocks are insanely overpriced than you’d go with when stocks are fairly priced or low-priced, and most of the risk associated with buying stocks no longer applies for you. Yet you obtain higher returns! Investor heaven!


This approach (Valuation-Informed Indexing) sounds so easy and so rewarding and so rooted in common sense. Why doesn’t Mike Piper follow it? Why doesn’t everybody follow it?
Stock investing is an intensely emotional endeavor. When stocks were priced at three times fair value in 2000, the numbers on the bottom line of the last page of our portfolio statements overstated by a factor of three the amount of lasting wealth we had accumulated up to that time. We all wanted to believe that it was the portfolio statements that had it right and the last 30 years of academic research that had it wrong.


We tell ourselves that index funds always work even though there is a voice of common sense within each of us that tells us that it cannot possibly be so. How could there ever be an asset class that is worth buying at any price?


Mike uses numbers in his arguments. But it is emotion that drives his analysis of the numbers and it is emotion that makes Mike’s analyses popular with his readers.  Mike and his readers very, very, very much want to believe that index funds work during bear markets. But it is not so, at least not according to the 140 years of historical data available to us today.