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
The benefits of index investing include low cost, requires little financial knowledge, convenience, and provides diversification. Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).
What are 2 cons to investing in index funds? ›
The benefits of index investing include low cost, requires little financial knowledge, convenience, and provides diversification. Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).
What are the dangers of index funds? ›
Asset prices can rise and fall rapidly and investors must accept the fact that the value of their index based investment may fluctuate by as much as 50% or more in a year. General market risk can relate to a particular sector. For example, mining sector indices are usually more volatile than industrial sector indices.
Is it bad to have too many index funds? ›
The addition of too many funds simply creates an expensive index fund. This notion is based on the fact that having too many funds negates the impact that any single fund can have on performance, while the expense ratios of multiple funds generally add up to a number that is greater than average.
Is investing in an index fund enough? ›
Over the long term, index funds have generally outperformed other types of mutual funds. Other benefits of index funds include low fees, tax advantages (they generate less taxable income), and low risk (since they're highly diversified).
Why not to invest in 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.
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.
What is the main disadvantage of investing in index funds? ›
However, an index fund does not have that flexibility as it has to be fully invested in the index at all points of time. 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.
Do index funds ever lose money? ›
All investments carry risk. An index fund, like anything else, can potentially lose value over time. That being said, most mainstream index funds are generally considered a conservative way to invest in equities (although there are lesser-known index funds that are thought to carry greater risk).
Why not just invest 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.
It's easy to see why S&P 500 index funds are so popular with the billionaire investor class. The S&P 500 has a long history of delivering strong returns, averaging 9% annually over 150 years. In other words, it's hard to find an investment with a better track record than the U.S. stock market.
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.
How long should you keep your money in an index fund? ›
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.
Is it wise to only invest in index funds? ›
Investing legend Warren Buffett has said that the average investor need only invest in a broad stock market index to be properly diversified. However, you can easily customize your fund mix if you want additional exposure to specific markets in your portfolio.
Should you put all your money in index funds? ›
To be sure, if you have the time, knowledge, and desire to create a portfolio of individual stocks, by all means, go for it. But even if you do own individual stocks, index funds can form a solid base for your portfolio. Index funds offer investors of all skill levels a simple, successful way to invest.
What is the average return on index funds? ›
The average stock market return is about 10% per year, as measured by the S&P 500 index, but that 10% average rate is reduced by inflation.
What are the cons of investing in index funds? ›
Cons of Index Funds
- Less Flexibility. While your portfolio is less affected by a declining singular asset, it's not immune to the fluctuations of the larger market, including economic downturns and bear markets. ...
- Moderate Annual Returns. ...
- Fewer Opportunities for Short-Term Growth.
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.
What would be some cons of investing in this bond index fund? ›
Cons of bond ETFs
- Expense ratios may be relatively high. If there's an area where bond ETFs have drawbacks, it could be in their expense ratios – those fees that investors pay for the manager to handle the fund. ...
- Potential low returns. ...
- No guarantees of principal.
Major differences between mutual funds and index funds.
| Index funds | Non-index mutual funds |
|---|
| Lower fees | Variable fees |
| Fewer investment choices (since the aim of an index fund is to track an existing index) | Many investment choices |
| Less research required | More research required |
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