Index yourself but stay invested: the key to long-term success

Let us recall the advantages of indexing

Index management (or passive management), which, let’s remember, consists of investing through the main indexes (either with index funds or ETFs) has made investing somewhat easier… at least in theory.

Indexed portfolios, such as the ones we propose at inbestMe, combine index funds in order to diversify and adjust the investment to the investor’s objective/risk profile.

Our indexed portfolios seek to match rather than outperform the market, have extremely low fees and are tax optimized.

If you take out one or more portfolios of index funds, hold them for decades and do nothing else, you are likely to outperform almost everyone who tries to outperform the market by speculating, including most professionals. There is statistical evidence to prove it.

Be inspired but don’t make mistakes

However, despite the statistics, most investors do not achieve reasonable returns. Most investors continue to invest in traditional, inefficient and expensive mutual funds and/or financial services. In Spain, indexation barely represents 2%. In Europe, not much more.

But studies show that even investors who index do not get the expected results. In other words, what seems easy in the end is not so easy according to the following results.

Morningstar publishes an annual report that compares investors’ returns with the returns of the funds in which they invest. For the first time, the 2024 report also includes differences in ETFs.

In this study, mutual fund or ETF returns are calculated as if an investor had purchased at the beginning of the period analyzed, reinvesting all income or capital gains, with no withdrawals. This method reflects the fund’s performance as a static investment, but does not consider the actual behavior of most investors.

While some investors choose to buy and hold their investments, others buy and sell frequently, influenced by financial or emotional changes. To reflect this reality, Morningstar offers an alternative measure: investor returns, which take into account actual cash flows into and out of funds during the period.

Investors who adopt a buy-and-hold strategy typically earn investor returns close to the reported total returns of their funds. In contrast, those who buy at high prices and sell at low prices typically experience returns significantly below those reported by the fund.

Over the past 10 years, through Dec. 31, 2023, Morningstar’s research found that, on average, investors earned 6.3% annually, which is 1.1 percentage points less than the returns of the mutual funds and ETFs they owned. This result is consistent with previous Morningstar research. 1.1% per year may not seem like much, but in the table below we see how this can turn into very significant amounts due to the effect of compound interest and time (e.g., up to €24,458 for a €100,000 investment over 20 years).

Es casi inevitable que exista una pequeña diferencia en la rentabilidad, ya que los inversores generalmente no invierten todo su dinero desde el inicio. Incluso para aquellos que son capaces de comprar y mantener sin perseguir rendimientos ni vender en pánico durante caídas del mercado, la paciencia es fundamental. Sin embargo, muchos inversores carecen de paciencia y frecuentemente realizan apuestas a corto plazo en segmentos o sectores específicos del mercado. Debido a sus menores costos y su mayor alineación con los índices de referencia, los fondos indexados o ETFs se han convertido en el vehículo preferido también para estrategias especulativas a corto plazo.

Studies on this topic are not new and we have discussed in this blog why we generally fail as investors, performing worse than would be reasonable.

In fact, we periodically publish our returns, and we know that these differences can reach 4.4% per year or 43% accumulated, causing really large differences as shown in the following table where we repeat the previous table, but using 4.4%: this difference becomes €136,957 in 20 years for the same investment.

Plan your objectives, be flexible and be patient.

Index funds are very efficient and cost-effective instruments, but that in itself does not guarantee a return.

This data shows that statistically chasing gains leads to capturing losses.

Avoid this and stay disciplined and don’t make impulsive investment decisions.

Establish clearly what your financial objectives are and segregate them as much as possible by horizons by investing in different types of portfolios depending on whether they are short, medium, or long term: this will help you better navigate market volatility and reduce the possibility of panic selling at a bad time. Beyond behavioral errors, we may be making mistakes in our financial planning.

If you feel the need to speculate, limit yourself to a small part of your wealth, for example no more than 5% unless you are an expert, but above all do it only if you have great discipline, time and a very good control of your financial psychology.

To repeat what we said at the beginning in other words: if you buy one or more portfolios of index funds (or ETFs), automate them, forget about them for decades and dedicate yourself to living life, it is very likely that you will outperform all those investors who make it difficult for themselves trying to beat the market.