Outside the Box: Why index investing still rules — even during a pandemic-fueled market meltdown

A funny thing happened on the way to certain stock market doom.

Nothing.

Just a few months ago, passive investing was regularly made out to be the latest investment boogeyman. Wall Street pundits called it everything from “thinly veiled Marxism” to the “biggest bubble in history.”

Barry Rithotlz, a money manager with a great Bloomberg News column, points out that when push came to shove over COVID-19 and markets fell, it wasn’t the index fund investors who bolted.

Instead, it was the supposed “smart money” in actively managed mutual funds.

“As the selloff progressed, Wall Street pros panicked and sold while moms and pops stayed calm and bought,” Ritholtz writes.

“One can’t help but think that some of this is explained by psychology: The professionals are the ones whose bonuses and perhaps even their jobs are on the line. Retail investors looked to take advantage of a price drop.”

As Ritholtz notes, there is a real “reaction gap” between small investors and Wall Street’s so-called elite. I would add that there’s another, similar gap between what you hear from Wall Street and what’s going on among the world’s truly big investors — the major pension funds, foundations and university endowments.

Read: A recession won’t end the FIRE movement, but it will change it for the better

Unlike Wall Street traders, large institutional pools such as endowments have time horizons that are virtually infinite. And while retirement investors do not get to enjoy infinity as a point of view, they do typically have decades of investing ahead of them.

Near-retirees should be thinking about how long they might live in retirement, and that could easily be more than 10 years. Even if your time horizon is just five years, the historical data shows that selling in a downturn is the worst possible course of action.

Read: Entering retirement in the middle of a health and financial crisis? How to handle your money and your emotions

Stuck in the middle

So who’s in the middle, selling like mad and forcing down stocks? The active fund managers who must report big gains every quarter or lose clients like sand through their fingers.

Burt Malkiel, the Princeton professor who wrote the investment classic “A Random Walk Down Wall Street,” has been writing and talking about this problem for years. (Disclosure: Malkiel is also on the investment committee of my firm.)

What Malkiel saw decades ago, and what we now see proven as pandemic panic hits the stock market, is that mutual-fund managers cannot serve two masters. They cannot get great long-term gains and great short-term gains. It’s too often one or the other.

Reams of academic data bear out this reality. The problem is that the incentive for active managers is to focus solely on the short run — at the expense of long-term results.

Active fund managers know this. So the tactic has been to make investors think of index investing as a mediocre choice, a move toward a market “average” that isn’t so impressive.

In practice, the opposite happens. Low-cost compounding cannot help but exceed the performance of the costly, short-run active manager who must scramble each quarter to get paid.

“For me the best way to keep the cost down and to get not average returns, but to get above average returns, is to make index funds the broad core of every investment portfolio,” Malkiel explains. “I do this myself in my own investment funds.”

Read: Market got you down? How to construct a comeback portfolio

High risk, low rewards

Don’t own stocks, own the market SPX, -3.37%, Malkiel has long maintained, and over time you will beat even the sharpest minds on Wall Street. The impact of COVID-19 on stocks simply sped things up, like a time-lapse film of a tree growing from a seed.

“You won’t be average,” Malkiel says. “You will be above average because the typical actively managed fund underperforms the index fund, and the amount of that underperformance is very well estimated by the difference in expense ratios.”

COVID-19 is a human tragedy with real economic costs in the short term. Hopefully it will end soon.

Nevertheless, trying to trade profitably amid chaos is a high-risk, low-reward venture, one that’s hardly advisable for anyone, much less retirement investors.

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