For most long-term investors, any time can be the best time to invest in index funds. But, certain market conditions give index funds an advantage over actively managed funds. There are also times when stock index funds are best, and times when bond index funds are best.
When Should You Invest in Index Funds?
There is no foolproof method for predicting what types of mutual funds will perform better than others. This is especially true during short-term periods, such as one year or less. However, some conditions can make index funds a smarter choice.
During a strong bull market—when stock prices are rising across all sectors and mutual fund types—active funds may lose their advantage. In a bull market, 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 year of a 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 its peers.
Recessions often lead people to buy bonds. However, bond markets can be difficult to navigate. 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 recovery slipped in 2011, and stock funds were lucky to escape negative returns, VBMFX beat 85% of all intermediate-term bond funds.
What Is Dollar-Cost Averaging?
For people who are looking to offset market volatility, dollar-cost averaging is a good option. This strategy involves investing a fixed amount of money at regular intervals. For example, you might decide to invest 15% of your salary in your company's 401(k). In that case, you would likely opt to have 15% deducted from each paycheck.
Whether you contribute monthly, quarterly, or yearly, dollar-cost averaging works. It ensures that you're not investing a lump sum amount in 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. If you do that over time, those extra shares can add up.
When Should You Choose Mutual Funds?
The most common time when index funds lose to actively managed funds is when markets turn volatile. In such an environment, a skilled (or lucky) active fund manager can sift through and find the stocks or bonds that can outperform the major market indices.
That kind of market is often called a "stock picker's market." As in any market environment, certain sectors can perform better than others. The main problem with mutual funds, however, is the fees. Some have expense ratios above 1%, which can eat away at a lot of your returns.
A difference of 0.5% to 1% in expense ratios may not seem like much, but over 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 of index funds provide an edge. In the long run, this helps them beat most actively managed funds. Lower costs often 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. In combination with actively managed funds, they can help you build a solid long-term portfolio. Vanguard, Fidelity, and Charles Schwab are reputable companies with a good variety of low-cost index funds.
The Balance does not provide tax or investment advice or financial services. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.