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A reality check for newbie index investors

As the baseball season marches on, my beloved Blue Jays continue to flirt with last place in the American League East, a position they've clung to since Opening Day. Yet despite the team's dismal record, the Jays rank first in the league in attendance, averaging close to 40,000 fans per home game. After back-to-back playoff appearances, the Jays still seem to have a devoted and patient following.

Unfortunately, investors are much less loyal than baseball fans. They love a strategy when it delivers high returns, but at the first sign of trouble, they boo and throw beer cans. That's one of the reasons investing is so difficult: It requires you to endure the inevitable losing streaks with discipline and long-term focus.

As a long-time advocate of index investing, I'm pleased that more and more people are adopting this strategy. CNBC reported in April that in 2016 alone, U.S. investors pulled $264.5-billion (U.S.) out of actively managed equity funds and put almost as much ($236.1-billion) into passive index funds and ETFs. The uptake has been slower in Canada, but the trend is similar – and hugely encouraging.

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But I'm worried many of these new indexers may be bandwagon fans, swept up in the euphoria of this long bull market. When stock and bond indexes finally stumble – as they must, eventually – these investors may not show the fortitude we see in long-suffering Toronto sports fans.

Indexing – which is designed not to beat the market but simply to match its returns at the lowest possible cost – always shines during periods of prosperity. And let's face it, the markets have enjoyed a remarkable ride. Over the five years ended June 30, the annualized return on U.S. stocks was over 20 per cent, while international stocks delivered more than 14 per cent. Even Canadian equities – the laggard in the group – delivered about 8.7 per cent annually.

More than that, these stellar returns came with few interruptions. Market volatility was significantly lower than average, and although we had a handful of corrections and even a couple of peak-to-trough declines of 20 per cent (the usual definition of a bear market), these downturns were short-lived and followed by swift recoveries.

Even bonds, the most hated of asset classes these days, surprised just about everyone over the last five years: Broad-market bond indexes returned more than 3 per cent as interest rates continued to trend down until the Bank of Canada finally raised its overnight rate this month.

All of which means if you simply bought, held and rebalanced a portfolio of index-tracking ETFs, your performance since mid-2012 would have been outstanding. A traditional portfolio of 40-per-cent bonds and 60-per-cent stocks (divided equally among Canada, the U.S. and international markets) delivered between 9.5 per cent and 10 per cent annually. That was enough to turn $10,000 into almost $16,000.

But here's the thing: The good times can't last. I'm not being bearish here, nor am I making any forecasts about where the stock and bond markets are heading. I have no clue, and neither does anyone else, no matter how confident they may sound. But I do feel comfortable saying that 10-per-cent returns with little volatility won't continue forever, and I hope new indexers aren't naively expecting them to.

It's worth reflecting on this idea now, because when the bear finally shows its teeth, investors will be too frightened to think rationally. Here's a reality check:

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Downturns can be sudden and brutal.

Like a ball club blowing a big lead late in the game, markets can get ugly quickly. Bear markets are not usually slow, gradual trends: More often, they see a series of sharp losses over brief periods, followed by panic that causes prices to fall even further. It's enough to shake the confidence of even a seasoned investor. But swift declines are not a sign that your strategy is broken.

An index fund, in particular, offers no defence because it is fully invested all the time: There's no manager who can move to cash to reduce short-term losses. So if you're not able to endure a drawdown of 40 per cent to 50 per cent in your investments – and few people are – then you need to reduce your risk by adding some bonds, guaranteed investment certificates or cash to your portfolio. The time to do this is now, not after your portfolio is gutted.

Active managers will prey on the opportunity.

Money managers and advisers love to say that indexing only works well during bull markets, and tough times require a more hands-on approach. Unlike index funds, active funds can move to cash or to more defensive sectors, and this can indeed slow the bleeding.

But can active managers be expected to consistently outperform during bear markets? The evidence suggests otherwise. The annual SPIVA reports from Standard & Poor's measure the number of active funds that outperformed their benchmark indexes over various periods. During a difficult 2011 (remember the European debt crisis and the fiscal cliff in the United States?), the report found that fewer than one in six U.S. equity funds outperformed the broad market. Most active funds also lagged their benchmarks during the bloodbath of 2008, as well as the three-year period (2000-02) following the dot-com crash.

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Indexing works in all markets.

While it might be true that indexing shines particularly bright during bull markets, it's an all-weather strategy.

Indexing works not because stocks always go up, but because it relies on low cost, broad diversification, tax efficiency and a disciplined process. The strategy does not guarantee absolute returns, but it does offer your best chance at capturing whatever the markets deliver.

As long as you don't abandon it along the way.

Dan Bortolotti, CFP, CIM, is an associate portfolio manager at PWL Capital in Toronto. He is the creator of Canadian Couch Potato, an award-winning blog about index investing.

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