When Is the Best Time to Invest in Index Funds?
Best Times to Buy Index Funds: Stock Index Funds & Bond Index Funds
For most long-term investors, any time can be the best time to invest in index funds; however, certain market conditions give index funds an advantage over their actively-managed fund counterparts. There are also times when stock index funds are best, and when bond index funds are best.
When to Invest in Index Funds
There is no foolproof method for predicting what types of mutual funds will perform better than others during any given timeframe, especially short-term periods, such as one year or less. However, some conditions can make index funds a smarter investment choice than actively-managed funds.
During a strong bull market— when stock prices are rising across all sectors and mutual fund types—active fund managers may lose their advantage because strategic buying and selling has just as much chance of losing to the major market indices as matching or beating them. For example, in 2006, when the market was in the final calendar year of its previous bull run, Vanguard 500 Index (VFINX) beat more than 75% of large blend funds. In 2010 and 2011, when stocks were in full recovery mode after the 2008 bear market, VFINX beat 70% and 80% of category peers, respectively.
Weak economic conditions often lead people to bonds. However, bond markets can be difficult to navigate, and bond fund managers with active-management strategies often learn this the hard way: by losing to index funds like Vanguard Total Bond Market Index (VBMFX). For instance, when the economic recovery slipped in 2011, and stock funds were fortunate to escape negative returns, VBMFX beat 85% of all intermediate-term bond funds.
For people looking to offset the impact of market volatility, the dollar-cost averaging investment strategy is a good option. Dollar-cost averaging involves spending a fixed amount of money on an investment at regular intervals—whether monthly, quarterly, or yearly. In the long run, dollar-cost averaging is very beneficial because it ensures you're not investing a lump sum amount into a stock or fund while it's at a high price point. On the other end, you put yourself in a position to take advantage of market drops and purchase them at a low cost.
Let's assume you bought 250 shares of Company ABC at $20 each for $5,000 total. If you used the dollar-cost averaging strategy and split that $5,000 into four purchases at prices of $10, $20, $25, $30, you would end up with just over 279 shares. When done over time, those extra shares that you end up with can add up to a substantial amount.
When to Choose Mutual Funds
The most common time when index funds lose to actively-managed funds is when markets turn volatile—an environment where a skilled (or lucky) active fund manager can sift through the stocks or bonds that can outperform the major market indices. This kind of market is often called a stock picker's market, and as in any market environment, certain sectors can perform better than others. The main problem with mutual funds, however, are the expensive fees. With some having expense ratios above 1%, they can eat away at a lot of your returns. A difference of 0.5–1% in expense ratios may not seem like much, but in the long-term, it adds up.
The Bottom Line
There is no way to predict what the market will do in any given time frame, but the passive nature and low-cost structure of index funds provide a performance edge that helps them beat the majority of actively-managed funds in the long run. Lower costs generally translate to better long-term returns, and you don't have to deal with the irrationality of human nature. Index funds are smart tools for diversification and can be used wisely in combination with actively-managed funds to build a solid long-term portfolio. Vanguard, Fidelity, and Charles Schwab are reputable companies with a good variety of low-cost index funds.
The information on this site is provided for discussion purposes only and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.