Best Time to Invest in Index Funds

Index Funds Can Be Strategic in the Short Term and Wise in the Long Run

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For most long-term investors, any time can be the best time to invest in index funds; however, there are certain market conditions that give index funds an advantage over their actively-managed fund counterparts.

Why are index funds generally the best investment choices for long-term investors? The short answer is that their passive nature and low-cost structure provide a performance edge that helps them beat the majority of actively-managed funds in the long term. Lower costs generally translate to better long-term returns.

But what about short-term strategies for index funds? When is the best time to invest in index funds? Are there certain market conditions that make index funds a better idea than actively-managed funds? Let's get on with answering these questions.

When Index Funds Beat Actively-Managed Funds

Before going further with the passive vs active debate, it should be noted that there is no absolute, fool-proof method for predicting what types of mutual funds will perform better than others during any give time frame, especially short-term periods, such as one year or less.

But there are conditions that can make index funds a smarter investment choice than actively-managed funds:

  • Strong Bull Markets (Stocks): 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. And 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 (Bonds): 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 example, when the economic recovery slipped in 2011, and stock funds were fortunate to escape negative returns, bond funds had a positive year. But bond index funds had a great year. VBMFX beat 85% of all intermediate-term bond 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, there are also certain sectors that can perform better than others in volatile markets.

Using Index Funds Wisely

The bottom line is that there is no way to predict what the market will do on a year-by-year basis, or for any given time frame for that matter. Index funds can be smart tools for diversification and can be used wisely in combination with actively-managed funds to build a solid long-term portfolio.

The most reputable companies with a good variety of low-cost index funds include Vanguard, Fidelity and Charles Schwab.

Disclaimer: 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.