Index funds have earned their popularity for good reason.
They are generally low-cost, transparent, tax-efficient, and difficult for many active managers to beat consistently. For a long-term investor, “buy a diversified portfolio, keep costs low, and stay invested” is still a very reasonable foundation.
But there is an important distinction that sometimes gets lost:
A good investment strategy is not the same thing as a complete financial plan.
The first decade of this century is a useful reminder.
From January 2000 through December 2009, the S&P 500 produced an annualized total return of approximately -0.95%. In other words, even including dividends, an investor in U.S. large-cap stocks went essentially nowhere for an entire decade.
That period included two major bear markets: the collapse of the technology bubble and, only a few years later, the global financial crisis.
Today, looking backward, it is easy to say that investors simply needed to stay the course. And for a younger investor who was continuing to earn income and regularly buying more shares, that may have been exactly the right response.
But consider someone in a very different position.
Same Market. Very Different Experience.
Imagine two investors entering the year 2000 with $1 million.
One is 40 years old, still working, and continuing to contribute to retirement accounts every year.
The other is 65, has just retired, and needs $50,000 or $60,000 per year from the portfolio to support retirement.
Both experience the same market.
But they do not experience the same financial outcome.
The 40-year-old is able to keep buying during periods of depressed prices. Time is on his side, and a difficult decade may actually create attractive opportunities for long-term accumulation.
The retiree faces a very different problem.
He is no longer simply waiting for the market to recover. He is withdrawing money while it is down. Each withdrawal can mean selling investments that will no longer be there to participate in the eventual recovery.
That is sequence-of-returns risk, and it is one reason why a long-term average return can be a misleading way to think about retirement.
A portfolio might average a perfectly respectable return over 30 years. But if the worst returns happen during the first five or ten years of retirement, the outcome can look very different than if those same poor returns arrive much later.
Indexing Does Not Eliminate the Need for Diversification
There is another lesson in the lost decade.
Owning an S&P 500 index fund means owning a broad group of large U.S. companies. It does not mean owning the entire investment universe.
During 2000–2009, several areas outside U.S. large-cap stocks performed considerably better, illustrating why diversification across markets, company sizes, and investment styles can matter.
Diversification does not guarantee a positive return, nor does it ensure that every part of a portfolio will perform well at the same time.
That is actually the point.
We diversify because we do not know in advance which area of the market will lead during the next decade.
The Portfolio Is Only One Part of the Plan
None of this is an argument against index funds.
It is an argument against assuming that buying an index fund solves every financial problem.
A retiree also needs to consider where near-term spending will come from, how much liquidity to maintain, when to claim Social Security, which accounts to withdraw from first, whether Roth conversions make sense, how taxes affect withdrawals, and how much flexibility exists if markets struggle for several years.
Those decisions can matter enormously during a period when investment returns are disappointing.
The lesson of the lost decade is not that investors should have predicted it or found a way to avoid every decline.
It is that a financial plan should not depend on our ability to predict what the next decade will look like.
Markets may deliver strong returns. They may deliver disappointing ones. They will almost certainly deliver them unevenly.
At Hanover, our job is not to pretend we know which kind of decade comes next. It is to build a plan that can adapt to whichever one arrives.
The portfolio matters. But the plan is what tells the portfolio what it needs to do.