Index investing is a strategy that involves creating portfolios around a stock index, a benchmark, or a market average. The idea is that, since most fund managers fail to outperform the market, the optimal way to invest in a diversified portfolio is to track an index—such as the S&P 500 Index—while minimizing costs and fees. Index investing is often used synonymously with the term passive investing, but there are a handful of reasons why some people believe that the average investor should avoid index funds altogether. Here are five of those reasons.
Key Takeaways
- Index investing is a popular investment strategy, but there are also reasons why some investors might want to avoid index funds.
- While indexes may be low cost and diversified, they prevent seizing opportunities elsewhere.
- Moreover, indexes do not provide protection from market corrections and crashes when an investor has a lot of exposure to stock index funds.
1. Lack of Downside Protection
The stock market has proved to be a great investment in the long run, but over the years it has had its fair share of bumps and bruises. Investing in an index fund, such as one that tracks the S&P 500, will give you the upside when the market is doing well, but also leaves you completely vulnerable to the downside.
Investors with heavy exposure to stock index funds can choose to hedge your exposure to the index by shorting S&P 500 futures contracts, or buying a put option against the index, but because these move in the exact opposite direction of each other, using them together could defeat the purpose of investing (it's a breakeven strategy). In most cases, hedging is only a temporary solution.
2. Lack of Reactive Ability
Index investing does not allow for advantageous behavior. If a stock becomes overvalued, it actually starts to carry more weight in the index. Unfortunately, this is just when astute investors would want to be lowering their portfolios' exposure to that stock. So even if you have a clear idea of a stock that is overvalued or undervalued, if you invest solely through an index, you will not be able to act on that knowledge.
3. No Control Over Holdings
Indexes are set portfolios. If an investor buys an index fund, they have no control over the individual holdings in the portfolio. You may have specific companies that you like and want to own, such as a favorite bank or food company that you have researched and want to buy. Similarly, in everyday life, you may have experiences that lead you believe that one company is markedly better than another; maybe it has better brands, management or customer service. As a result, you may want to invest in that company specifically and not in its peers.
At the same time, you may have ill feelings toward other companies for moral or other personal reasons. For example, you may have issues with the way a company treats the environment or the products it makes. Your portfolio can be augmented by adding specific stocks you like, but the components of an index portion are out of your hands.
4. Limited Exposure to Different Strategies
There are countless strategies that investors have used with success; unfortunately, buying an index of the market may not give you access to a lot of these good ideas and strategies. Investing strategies can, at times, be combined to provide investors with better risk-adjusted returns. Index investing will give you diversification, but that can also be achieved with as few as 30 stocks, instead of the 500 stocks that the would track.
If you conduct research, you may be able to find the best value stocks, the best growth stocks and the best stocks for other strategies. After you've done the research, you can combine them into a smaller, more targeted portfolio. You may be able to provide yourself with a better-positioned portfolio than the overall market, or one that's better suited to your personal goals and risk tolerances.
5. Dampened Personal Satisfaction
Finally, investing can be worrying and stressful, especially during times of market turmoil. Selecting certain stocks may leave you constantly checking quotes, and can keep you awake at night, but these situations will not be averted by investing in an index. You can still find yourself constantly checking on how the market is performing and being worried sick about the economic landscape. On top of this, you will lose the satisfaction and excitement of making good investments and being successful with your money.
The Bottom Line
There have been studies both in favor and against active management. Many managers perform worse than their comparative benchmarks, but that does not change the fact that there are exceptional managers who regularly outperform the market. Index investing has merit if you want to take a broad economic view, but there are many reasons why it's not always the best route to achieving your personal investing goals.
FAQs
Challenges of Investing in Index Funds
While index funds are free from the fund manager bias, they are still vulnerable to the risk of tracking error. It is the extent to which the index fund does not track the index.
Why shouldn't you invest in index funds? ›
Challenges of Investing in Index Funds
While index funds are free from the fund manager bias, they are still vulnerable to the risk of tracking error. It is the extent to which the index fund does not track the index.
What is the main disadvantage of index fund? ›
Key Takeaways
Index funds are a low-cost way to invest, provide better returns than most fund managers, and help investors to achieve their goals more consistently. On the other hand, many indexes put too much weight on large-cap stocks and lack the flexibility of managed funds.
Should I keep my money in index funds? ›
Index funds often perform better than actively managed funds over the long-term. Index funds are less expensive than actively managed funds. Index funds typically carry less risk than individual stocks.
Do billionaires invest in index funds? ›
The bottom line is that even billionaires recognize the wealth-creation potential of low-cost index funds. Even if you're an active investor in individual stocks -- like Buffett and Dalio are -- rock-solid index funds like these four can help form an excellent backbone for your portfolio.
Why don t more people invest in index funds? ›
Another reason some investors don't invest in index funds is that they may have a preference for investing in a particular industry or sector. Index funds are designed to provide exposure to broad market indices, which may not align with an investor's specific interests or values.
Is my money safe in index funds? ›
Safety in Index Funds? Perhaps because of their popularity, index funds are sometimes perceived to be the safest way to invest. The benefits above are not to be ignored, but index funds are not necessarily safe investments. Put another way, they're not substantially safer or riskier than any other type of mutual fund.
Are index funds safe during a recession? ›
The important thing to remember about index funds is that they should be long-term holds. This means that a short-term recession should not affect your investments.
Why index funds are very high risk? ›
While indexes may be low cost and diversified, they prevent seizing opportunities elsewhere. Moreover, indexes do not provide protection from market corrections and crashes when an investor has a lot of exposure to stock index funds.
What happens if everyone invests in index funds? ›
That's because as long as we have a stock market, we WILL have active traders trying to beat the market. If the market becomes less efficient as more investors shift to index funds, it only increases the likelihood that some investors will shift to active investing to take advantage of the inefficiency.
Ideally, you should stay invested in equity index funds for the long run, i.e., at least 7 years. That is because investing in any equity instrument for the short-term is fraught with risks. And as we saw, the chances of getting positive returns improve when you give time to your investments.
Can you live off index funds? ›
Once you have $1 million in assets, you can look seriously at living entirely off the returns of a portfolio. After all, the S&P 500 alone averages 10% returns per year. Setting aside taxes and down-year investment portfolio management, a $1 million index fund could provide $100,000 annually.
Do financial advisors beat index funds? ›
Study after study shows that it's really tough to outperform index funds over the long-term after accounting for fees. Those that manage to beat the market usually do so by taking on more risk (via leverage or other means) or get lucky with the equivalent of 10 consecutive heads in a coin-flipping contest.
What are the 4 index funds to retire a millionaire? ›
You can build a powerful, global portfolio with these four Vanguard ETFs: Vanguard Total Stock Market ETF (NYSEMKT: VTI), Vanguard Total International Stock ETF (NASDAQ: VXUS), Vanguard Total Bond Market ETF (NASDAQ: BND), and Vanguard Total International Bond ETF (NASDAQ: BNDX). That's really all you need.
Where do the richest people invest? ›
Ultra-wealthy individuals invest in such assets as private and commercial real estate, land, gold, and even artwork. Real estate continues to be a popular asset class in their portfolios to balance out the volatility of stocks.
What is Warren Buffett's rate of return? ›
Warren Buffett is an investing legend. To be fair, with his company Berkshire Hathaway averaging an annual return of around 20%, it's easy to see why. It goes without saying, returns of that stature are amazing.
What are the risks of investing in index funds? ›
While they offer advantages like lower risk through diversification and long-term solid returns, index funds are also subject to market swings and lack the flexibility of active management.
Is it worth investing in index funds? ›
They can offer reasonable returns
But not every index fund does well. However, history shows that the stock market increases in value over time. It means, in the long run, index funds have the potential to provide investors with reasonable returns for a low cost, making them good value for money.
Why not invest everything in the S&P 500? ›
The one time it's okay to choose a single investment
That's because your investment gives you access to the broad stock market. Meanwhile, if you only invest in S&P 500 ETFs, you won't beat the broad market. Rather, you can expect your portfolio's performance to be in line with that of the broad market.
Do index funds ever fail? ›
Much of it, yes, but not entirely. In a broad-based sell-off of a market, the benchmark index will lose value accordingly. That means an index fund tied to the benchmark will also lose value.
