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4 Reasons Why Index Investing May Not Be for You





The personal finance blog world is all about index investing. Rightfully so as indexing provides a cheap, efficient, easy and profitable method of investing for the long run. Up until recently, my investing style has been a mix of indexing, stock picking and short term trading. However, after learning more about the benefits of indexing, the portion of my portfolio that is indexed is growing.

However, that is not the intention of this post. Not every strategy is perfect, not even the much coveted index investing. As I tend to enjoy stirring the pot a little, lets point out some of the pitfalls of index investing.

1. No Downside Protection

For indexers who are mostly equities over the past year, it’s more than likely that your portfolio has had some wild swings and is very volatile. The great thing about indexing is that when the markets go up the herd follows, however, the herd also is forced to follow when the markets tank.

2. No Control Over your Holdings

The index investor is at the mercy of whatever stocks that are the largest in any particular market. This can potentially lead to over priced stocks having a larger weighting on the index. Does anyone remember when Nortel was the largest stock on the TSX?

3. An Indexed Portfolio will Always be Average. Never Better, Never Worse.

If you’re like me, your aim is to “beat” the market not just float with it. Even though very few investors “beat” the market, an index investor will never do so. Even though the markets are generally efficient, there are always stocks out there that are oversold and under priced relative to their financial fundamentals. These stocks usually come roaring back much quicker than the index once the market realizes the pricing error.

4. It’s Boring.

This is probably the weaker of all the arguments, but it’s true, index investing is boring! If you’re the type that revels in digging in research, watching the markets, and investing when you think the time is right, then index investing is not for you. With index investing you set it and forget it making very few changes on an annual basis.

Comments?

As stated above, this post is meant to be the devils advocate to the popular index investing strategy.





56 Comments, Comment or Ping

  1. Investing should be boring, otherwise it is gambling.
    I agree with points 1 and 2, but I’m not sure for 3.
    Statistics I’ve read show that very low percentatge of the managed mutual funds (the stock pickers) beat the Index for long period of time.

  2. Good post FT!
    I actually believe that indexes are really good for people that don’t mind having a portfolio swinging up and down. However, I discovered that most people freak out after showing a negative result. I met several clients that wanted to switch to GIC’s after receiving their investment statement showing -4% while the market is -12%!

    They have a hard understanding that the fund was actually outperforming the market ;-)

    For those who can’t stand market fluctuation but can’t stand high MER’s (especially for Canadian resident!), there is an option:
    - Manage your fixed income yourself (bonds or GIC’s latter)
    - Buy cheaper mutual funds with the rest of your money

    Make sure that you don’t have fixed income in your mutual funds so you are actually paying a fund manager to do something.

    This way, you will be able to reduce your fees by 40% to 50% and you will still have smoother fluctuation than indexes.

  3. Given that most larger mutual funds are closet-index-huggers, I’m not really sure why there would be much difference in volatility between those funds and index funds. Most ‘average’ people invest in those funds.

    FT – question for u – do you beat the index? :)

  4. FP,
    If you mix your portfolio with fixed income, you will avoid major fluctuations without affecting that much your investment returns (this is the purpose of a good diversification, right?)

    However, this will definitely under perform any index. But I noticed that most people can’t stand volatility.

    They are all about stocks when it goes up and all about GIC’s when it goes down ;-)

  5. I figured this post would stir it up a bit, the heavy hitters are out!

    FP, I beat the Canadian index last year, but looks like i’m right on par with it this year as a good portion of my portfolio is indexed anyways.
    How about you FP? What percentage of your portfolio is indexed?

    FB, I agree with you, most people should have a portion of their portfolio in fixed income as it will reduce volatility without affecting their return too much. In my opinion though, if young people are in it for the long term, then it’s best to have a very high percentage in equities.

    MultifolDream$, I agree with you. I believe the stat is 75% of mutual fund managers do not beat the index.

  6. 6. The Reverend

    i haven’t read any studies showing the stats, but I would think 50% of actively managed funds beat the index and 50% don’t.

    another comment on why index funds might not be for you is that they invest in companies you wouldn’t from a moral perspective. there are ethical index funds out there but i think they’re quite a bit more expensive.

    also, one must be careful in comparing their self-managed portfolio of stocks to the index. unless you have a sizeable portfolio and are well diversified, i would venture to guess that you are taking on a lot more risk than would be inherent in the index as a whole. if you are taking on triple the volatility to beat the index by 50-75bps, you’re asking for trouble.

  7. 7. Gwaine

    Do you want to make your money like a gambler or like a casino?

    Gambling is exciting, has ups and downs, you can win big, you’ll probably lose big as the odds are against you.

    Casino’s make their money in boring ways, they don’t usually have big wins, they don’t usually have big loses, but on average they win as the odds are with them.

    I’ll take the casino approach and stick with my index funds thank you very much.

    Enjoy your actively managed funds gamblers, I’ll see you at my retirement party! :)

    Cheers,
    Gwaine

  8. FT – our portfolio is a bit of a hodge podge – 20% individual stocks which have done worse than the index this year, 50% index and about 30% low cost mutual funds and GICs.

    I haven’t looked at the performance of the mutual funds since the plan is to move them to ETFs at some point.

    At the end of the year I’ll do a performance evaluation – I have about 25% bond/75% equities and I don’t expect to be far from any relevant indexes.

  9. 9. The Reverend

    lol. i appreciate Gwaine’s comment.
    maybe a bit over the top but a good illustration

  10. It’s misleading to call the index “average”. Very few investors get long-term results as good as a stock index. This is true even of index investors because of attempts at market timing. Throwing your money into a stock index and forgetting about it for 30 years will put you in lofty company.

  11. If anyone is beating the Toronto Stock Exchange (TSX) Index over the past year or two, they have an extremely risky portfolio and I wouldn’t want it. Beating the index can only be judged long term, not year to year.

    I think the Boring point has merit for certain personalities. If following individual stocks gets your motor running and allows you to save more money so that you can buy ‘play’ more, than so be it. As long as you are playing wtih quality.

  12. I can’t agree with point #3 above and covered whether earning index returns only makes you average in the following artcile –

    http://ottawainvestmentadvisor.wordpress.com/2008/07/08/earn-above-average-investment-returns/

  13. FT – stirring up trouble eh? :) I might address these points in my own post – there’s too much to cover!

  14. You can’t just be an “index investor.” You must also be an “asset allocator.” This means selecting index funds in asset categories that are non-correlated. This controls volatility. The problem with managed funds is that their expenses are too high. They also tend to have a higher turnover which can increase the tax burden if held in taxable accounts.

  15. None of these supposed “downsides” hold up:

    1. If you want a “smoother” ride, add bonds and cash. While we are at it, add some REITs as well. There is no reason to think the average cross-section of stocks is more or less volatile than the index. Remember that when comparing a mutual fund to an index, you are comparing 95% stocks + 5% cash to a pure stock index.

    2. Yeah, so what? You still have “control” over how much to put in stocks, how much to put in foreign equities, how many trades you want to make every second, how many times you want to cross a dark highway – at night, blindfolded.

    3. An index investor will do better than the active investor 95 out of 100 times over 20 years. If that isn’t winning, I don’t know what is.

    4. So? You do realize not everyone will find reading through annual reports “exciting” right?

    For active investors, I’d suggest tracking their portfolio against a suitable benchmark and judging their stock picking skills from actual numbers. Are you doing better than the index after accounting for all expenses, taxes and your time? If not, why even bother?

  16. I feel that FT’s #2 is a very valid point, and I’ve yet to hear a counter argument to this point anywhere that makes me think otherwise. Look at Potash, RIM, Encana today and a similar them is emerging in Canada. Yes you could diversify away from this as CC mentions but what if you want that Canadian large cap exposure.

  17. 17. Sampson

    I think points 1,4 while decent arguments for why holding all your portfolio in indexed funds is bad, don’t hold up much when you consider, for (1) diversification (you could be holding something tracking bonds or other fixed income instruments), for (4) you can always allocate a small % to use other investing techniques. Example, although my wife and I share 100% of our assets, holdings under her name are almost all indexed, whereas I select my own stocks after analysis. Makes her more comfortable, and we have the chance to test my ‘picking’ skills and keeps me interested.

    Also, although many of the posts have made the point that not indexing equates to gambling, I wholeheartedly disagree. There are many academic studies describing methods/techniques to assess a company’s valuation and selecting individual stocks based on fundamentals and this simply is not gambling. Certainly individual stocks expose you to a bit more risk, but this risk can be minimized by holding multiple stocks and other portfolio management techniques.

    Lastly, I’d like to add to the list of why 100% indexing may not be right for you. I’m planning to start a family and while my wife is on Mat leave, we’ll likely transfer a significant portion (up to 10%) of our taxable portfolio to income trusts and other consistent high yielding vehicles. This is but one example where you would not want to have an unchanging ‘indexed portfolio’.

    I can however think of one group who should switch to “Indexing” – those buying Canadian Mutual funds. Lower than market returns, exorbitant fees.

  18. I agree on all your points… that’s why I suggest to many people to index their portfolio at 80% and be active on the remaining 20%.

  19. 19. EnRock

    Like Andrew and CC I’m reminded of the quote “index returns are above average returns”. Unfortunately as soon as you start actively trading you must not outperform the market, you must out perform the market plus transaction costs. Some individuals/managers may be able to consistently outperform the market, but is there any that have been able to outperform long term after transaction costs? Since we’re on the topic of IFA, they claim that even Warren Buffet hasn’t been able to achieve a better risk/return ratio than the indexes (See http://www.ifa.com/pdf/ifa-vs-buffett.pdf). If he can’t do it….

    IMHO the real question is no longer active vs passive, the question is what is the proper method for asset/sector/geographic etc allocation.

  20. 4 months from now, each of you gets the chance to disprove the other. The TFSA allows everyone a fresh slate to test their results in real dollar terms, and against a backdrop of a fresh year to compare each other. If everyone commits their $5k on January 2, we can see the results of indexing vs. active investing. A few years from now, we can see how everyone does.

    My opinion? With asset allocation you can reduce risk or add return vs. the index, and “beat the market” from a volatility or straight return perspective. The challenge in investing really comes down to asset allocation.

    Just my two cents.

  21. 21. Snickers

    I was looking at some index funds this morning even before I read your blog and was trying to cherry pick the best index funds out there and then checked out your blog and voila.. YOUR POST TODAY WAS ON INDEX FUNDS. I like your train fo thought and I agree with you when you say index funds are not for people who want to beat the market. But I think if we play our bets right we can still make money out of those people who just blindly follow the market..

  22. Index investing may be boring but it is also the easiest. Most people don;t have the time or competency to evaluate an individual company and estimate its potential value. but it is a lot easier for the average person to invest in an index, as it is far easier to predict and usually grows over time. There is nothing wrong with growing with the market is there? As long as you as you are not losing money :S

  23. I don’t think its an either or proposition.

    Everything foreign in my portfolio is indexed and domestic stocks are actively managed. I don’t remotely know enough outside my own environment to say this foreign stock is good or that one bad so I might as well track them all.

    You can index and take a part of your portfolio and be a mini Warren Buffet just as long as you understand that sometimes you start as a Buffet and end up as Fannie Mae.

  24. 24. Start-Up

    Reverend,

    Theoretically 50% of actively managed mutual funds should beat the index and 50% of actively managed mutual funds should lose to the index. This, however, does not take into account costs. Actively managed mutual funds cost more than index funds to invest. Additionally, actively managed mutual funds have more turnover and are less tax efficient. After taking those into consideration you will find index funds beat much more than 50% of actively managed funds.

  25. As usual great post FT. One other thing that might turn you off of indexing is the fact that in most indexes such as S&P 500 you don’t have any say as to the percentage allocation of each position in the index. This could distort your returns ( overweighting to financials in 2008 could have been a major drag for returns)

  26. 26. nl

    index investing does not mean all equities. You can easily have an index fund of short term bonds. This helps protect against volitile equity swings.

  27. 27. Fred

    Index investing is boring and for someone who was a more active investor, the minimal activity does take some getting used to.

    Downside protection can be achieved with the use of effective timers. On my blog I present a number of model portfolios which use timing and switch to either cash or bond ETF’s when my timer signals that I shouldn’t be long. Every model beats buy-and-hold hands down in terms of compound annual growth rate and ulcer index. One caveat though: the test period is short because the models use double exposure ETF’s and they haven’t been around for very long.

  28. 28. Brandon

    “Reverend,

    Theoretically 50% of actively managed mutual funds should beat the index and 50% of actively managed mutual funds should lose to the index. This, however, does not take into account costs. Actively managed mutual funds cost more than index funds to invest. Additionally, actively managed mutual funds have more turnover and are less tax efficient. After taking those into consideration you will find index funds beat much more than 50% of actively managed funds.”

    You also have to take into consideration that it is not always the same 50% of funds that beat the market each year. Even though you may own the top performing fund this year, next year it may get crushed by the market. There is no way of knowing in advance which funds will beat the market. As CC mentioned, indexers will beat active investors 95 out of 100 times over time periods of 20 years or more.

  29. 29. Jessica

    There are so many reasons why ETFs are for you.
    http://www.etfmarketpro.com/Pros-and-Cons-of-ETFs.html This link gives you a list of the pros, and also some cons that you did not mention above.

  30. 30. Ed Rempel

    Interesting article, FT. A couple of comments.

    First, there are fund managers that beat the index by wide margins (3-5%/year) over long periods of time (15-30 years). For example, there are the “Super investors of Graham and Doddsville”. One of our fund managers has beaten his index 100% of the time in rolling 60-month periods over 30 years. That is 360 5-year periods and he beat his index 100% of the time. This is after all fees. That can only be because of systematic inefficiencies in the market.

    Second, different markets have different levels of efficiency. Large cap US markets are the most efficient. Canadian large cap is also mostly efficient, but not very diversified. (Remember when the TSX60 was 48% Nortel?) However, many areas are much less efficient – international markets, emerging markets, small caps, specific sectors, illiquid stocks, private equity, and any stocks that are out of favour. There is a lot of opportunity for good investors to beat the markets in these areas.

    Third, ETF’s are a cool invention, but it seems obvious to us that ETF investors in general will underperform index investors. ETF’s are essentially indexes with a huge temptation to market time – most of which will be at the wrong times. Remember, studies show that 80-90% of all trades by all investors are stupid. People will try to market time ETF’s or pick the ones that have been “doing well”. One of the main advantages of indexes is that investors tend to hold them forever.

    Fourth, since indexes don’t control risk, index investing usually involves adding bond indexes. However, a skilled equity investor can create an equity portfolio with risk levels similar to an equity/bond index portfolio. In this case, an all-equity professionally managed portfolio should beat an index portfolio that has bonds.

    Ed

  31. 31. cannon_fodder

    I’d be curious to understand if those figures that tout 75%-80% of mutual fund managers can’t beat the indices also include those mutual funds which are essentially indices (for example iShares or Horizons Beta Pro).

    If you strip those out, then perhaps the difference is only 60%. After all, it is somewhat hard to criticize a fund manager if all they are supposed to do is basically be an index mutual fund.

  32. Thanks for having the guts to take the heat on this one! Index funds are definitely valuable, and they’re heavily covered and promoted for good reason. But I don’t think that broadening one’s perspective and branching out is a bad thing. The idea that anything other than index funds is gambling doesn’t fly with me. Index funds are great; it’s the dogma surrounding them that’s a problem.

  33. 33. Ed Rempel

    Good point, Cannon. Quite a few Index funds or index-type funds are included in the stats, and of course 100% of them make less than the index.

    A lot of the large main-stream mutual funds are closet indexers, as well. The fund management business can be risky if you are a fund manager working for a huge bank, insurance or mutual fund company, since an unpredictable market can get you fired. So, a lot of fund managers always make sure their allocation is not too different from the index. It is hard for these funds to beat the index when they have most of the same holdings and the same allocation.

    There are a lot of closet indexers and they are all included in the stats, as well.

    It would be very difficult to create an objective statistic excluding all the index, near index and closet index funds, since the closet indexers generally will not admit it.

    Ed

  34. 34. Patrick

    I agree: there are lots of other reasons not to like index investing:

    5. No money manager to blame when your investment loses money.
    6. All those compounding capital gains cost you lots of capital gains tax when you finally sell.
    7. Indexing earns so much money in the long run that eventually they push you into a higher tax bracket.
    8. You are so diversified that gains in any one holding make little difference.
    9. You miss out on the chance of investing your money with the next Warren Buffet.
    10. You miss out on the chance of investing your money in the next Wal Mart.

    Caveat Emptor!

  35. 35. Patrick

    @Start-Up: “Theoretically 50% of actively managed mutual funds should beat the index and 50% of actively managed mutual funds should lose to the index.”

    That is true only if the median equals the mean.

  36. 36. Al

    As a general rule, is everyone starts doing something (financially speaking) it turns into a bad idea. I suppose if everyone started indexing, then no one would be doing research to ensure an efficient market. I’m still going to keep indexing, however, until alot more people jump on the bandwagon.

  37. @Al – good point. If more people started indexing, a new equilibrium will simply be reached. If enough people started indexing then eventually money managers will be able to consistently exploit inefficiencies and some indexers would move to active management as value may actually be able to found there on a consistent basis. According to academics we are no where near this point though.

  38. 38. Patrick

    @Al – I’ve been thinking about that lately, but if the markets did become inefficient because of too much indexing, there would be an enormous incentive for some enterprising soul to find those inefficiencies and exploit them, there by bringing things back into balance.

    Too much indexing may increase volatility, I suppose, as a smaller and smaller fraction of the traders actually dictate the prices that the rest of us follow.

  39. 39. Gates VP

    Michael James:This is true even of index investors because of attempts at market timing…Throwing your money into a stock index and forgetting about it for 30 years will put you in lofty company.

    There’s a lot of backlash about market timing. I’ve read (& loved) Malkiel, I can understand where it’s coming from, but I want to be clear about one very important thing:

    Unless you plan on dying with your investments in the bank, you will be required to “time the markets” at least once.

    The common usage of “marketing timing” is really a shorthand for “trying to optimize mins and maxes”. But at some point in your life, you will likely want to trade in your investments for something else.

    So do be judicious and do understand your time limitations. It’s nice to plan that you’ll be holding the “stock index” for 30 years. But you really have to be open to the possibility that it could be 27 years or 35 years.

  40. 40. Jeff

    Was reading Carrick today on now being potentially the time to buy into Canadian banks (when isn’t frankly). Does anyone know of an ETF or other product that buys the big banks exclusively? Thanks!

  41. Jeff, XFN tracks Canadian financials.

  42. 42. Jeff

    Thanks Frugal. Was looking for one that’s a pure play on the Schedule A’s and I think you’re right that XFN is likely as close as it gets.

  43. 43. Ed Rempel

    Hi Patrick,

    I’m with you on “You miss out on the chance of investing your money with the next Warren Buffet.” Have you read the article by Warren Buffett “The Super-investors of Graham-and-Doddsville”? Here is a link: http://www0.gsb.columbia.edu/null/CIER?exclusive=filemgr.download&file_id=645551&showthumb=0 .

    Warren bumped into these 8 guys and new ahead of time that they would likely beat the indexes, and all of them did by huge margins over decades.

    Wouldn’t you much rather have any of these guys manage your money, rather than just having it in some index?

    Ed

  44. 44. Patrick

    @Ed – Of course I would. Now, if only I thought I could be as good as Buffet at spotting a superior stock picker…

  45. 45. DAvid

    Ed,
    Interesting article, though it’s about 25 years old. Have you any info on the performance of these individuals since 1984? Of late, W. E. Buffett seems to recommend Index funds for small investors, rather than managers.

    One of the questions an investor might ask is how to manage the transition from one star performer to the next, or is it built into the ‘progeny’ each creates? If you have a number of star managers which allows you to diversify, then you can move your funds as a manager retires, however if you have a single manager, how do you ensure continuity? I recognize that if one was to earn stellar returns for a decade or so, it would not be a problem to park money somewhere (money market) for a period while finding new managers, as it would take years for the market as a whole to catch up.

    The Indexer does not have to worry about changing horses.

    DAvid

  46. 46. Ed Rempel

    Hi Patrick,

    If you think that way, then why do you invest yourself? If you admit that Warren Buffett is a better investor than you, why would you not just buy Berkshire Hathaway stock with your entire portfolio? Do you actually think your DIY portfolio will out-perform Warren Buffett? Think about it.

    The advantage of investing is that you can hire the world’s best to invest for you.

    I have come to the conclusion that I will probably not ever make it as an NHL ass-star. Part of this is because I can’t skate, have not played hockey for 15 years, and am over 40. However, I believe I can still identify NHL ass-stars. For example, I think that Sidney Crosby, Dany Heatley and Evgeny Malkin are all super-stars and likely will continue to be for a few years.

    I don’t know how well you play hockey, Patrick, but do you think you could out-play any of my 3 picks?

    Similarly, I believe I can identify al-star fund managers, all of which would probably beat any portfolio of stock I would pick myself (if I still picked my own stocks).

    Over-confidence is one of the quite humurous insights into humans that come from Behavioural Finance, which is probably why so many people choose to be DIYers (plus it can be fund with small amounts of money) – even when they readily admit that they cannot beat Warren Buffett. For example, many polls show that 90% of all drivers believe they are above average.

    Ed

  47. 47. Ed Rempel

    Hi David,

    As you might expect, nearly all of those super-investors are now comfortably retired. They exception is Tweedy Browne, who have built a lasting investment firm. In the last 15 years, they have continued to beat the index by 4%/year compounded after fees – 11% vs. 7% for the MSCI EAFE (http://www.tweedy.com/content.asp?pageref=global ). Unfortunately, they don’t manage a fund in Canada.

    Choosing a replacement should not be that hard. After Wayne Gretzky retired, I would have picked Jaromir Jagr on offense and Nicklaus Lidstrom on defense.

    I think people have trouble picking good fund managers because they look too short term (less than 15 years) and they look for a hot fund manager instead trying to figure out how to identify the best. If you look for a hot hockey player that just had a scoring streak and a hatrick, you probably will not end up with Sidney Crosby.

    Warren Buffett’s comments are that indexes are better than an average mutual fund, but he would clearly still think that his style is better. He has not dumped his shares to buy an index. And I’m sure he still believes the same about the current super-investors of Graham-and-Doddsville.

    Ed

  48. 48. Ed Rempel

    Hi David,

    I missed something in my last post. Of the 8 investors in Buffett’s letter, 3 are still active – Tweedy Browne and of course Warren Buffett (the main person in the Buffett Partnership) and Charles Munger (Warren Buffett’s current partner).

    In other words, all 3 that are still active continued to massacre the indexes ever since.

    Ed

  49. 49. Patrick

    Ed – I would buy a share in BRK if I could afford one. :-)

    If you must know, a couple of the reasons I don’t put all my holdings in Berkshire Hathaway are that I don’t want all my eggs in one basket, and I don’t know what will happen to the company or the stock price when Mr Buffet dies.

  50. 50. Patrick

    Sorry, Ed, I just want to clarify something. Do you get the impression that I pick stocks? I don’t. I have a minuscule fraction (less than 1%) of my holdings in my brokerage account–basically just enough play money to learn that I’m a very poor stock picker.

  51. 51. David V

    I’m wondering if anyone can help me. I’ve got a reasonable stock portfolio, and currently have index funds. I was speaking to an investment advisor, never know when you can learn stuff, and mentioned I didn’t want actively managed funds because after costs so many of them don’t beat the market.

    He suggested that because most investors in actively managed funds are older, the funds themselves are meant to add a little bit of safety and that’s why they don’t beat the market. I think he was meaning they own bonds and the like.

    This seems like sales bs. That said, I’d like something to back me up. Any idea of links to these studies that show actively managed funds do so badly?

  52. 52. Start-Up

    @ David V

    I recommend reading John C. Bogle’s Common Sense on Mutual Funds, which gives you plenty of numbers as to why actively managed mutual funds are awful.

  53. Great thread of comments here. I’ll add my two cents: I don’t own much by way of index funds, but the individual stocks I own are heavily represented in the Toronto index and so if the index goes up, it’s largely on account of these stocks. So it’s practically like being in the index anyway.

    I guess my point is that not being invested in an index ETF/fund does not equate to “trying to beat the market.” I pick stocks, but I don’t imagine I will “beat the market”. I just don’t want to own every stock in every index, that’s all. I wouldn’t invest in a broad-based US index because I don’t want to own Coca-cola, etc.

  54. 54. Eric

    For the average investor who doesn’t want to be an “active” trader, then indexing might be the way for them. They can start with an index fund, and as they get more confident in their investment abilities, they could branch out to individual stocks.

    I personally have been following Natural Gas ETFs at http://naturalgasetfguide.com/

  55. 55. Ray

    I like index funds for the tax advantages, as many actively managed funds can both make you lose money and pay capital gain tax during the same period.

    Even if performance of funds isn’t guaranteed, the minimal fees are so i’d stay away from investments that cost more yearly than 0,35% for domestic / 0,50% for international / 0,65% for specialty sectors. Even when an ETF has low MER, it can become quite expensive when you factor in the trading costs of adding small chunks of money to it over many years.

    I think it is also important that my portfolio delivers average returns until it is large enough so I don’t have to care about temporary swings in its value. Like if I had only $1000 to invest, i would use index funds with the lowest management fees, but once my portfolio is large enough that i can lose (on paper only) $2000 in a single day without losing sleep over it, then picking funds and stocks makes sense.

    I think problem with index funds is twofold:

    With the growth of index investing, when a stock is included or excluded from an index, its value will change without regard to the fundamentals. As an exemple, if a company that was slightly too small to get included in an index grows enough, then all index funds will fight over the few available shares once it is part of the index. Which would drive the price up without any improvement in the fundamentals. On the other hand, if the situation of a company that is part of a small cap index or emerging market index improves too much, it can get kicked out of the index, so all the index funds will shortly sell all their shares, even at price below net asset value in order to track the index. This buy high and sell low effect brings the second point.

    Index tracking is more related to herd mentality than to value investing, as popular stocks represent a larger protion in a market cap weighted index than value stocks. Therefore one might wish to purchase the index fund plus a few individual stocks with a much lower p/e ratio than their sector. Or on the other hand, purchase the index and short the stocks that have a p/e ratio too high for their sector, so they can profit when these stocks will revert to the mean. Another exemple, some dividend aristocrats have the lowest earnings per share rate of their whole industry… are they compromising their growth just to increase dividends and stay part of the prestigious index? Thus not acting for the best interest of their shareholders.

    To summarize, index funds are the meat and potatoes of a meal, while it is hard to do without, you do not want to only rely on it for longs periods of time… unless you choose the “lazy portfolio” route and spend your time increasing your wages to be able to invest more instead of getting that 1% more return.

  56. 56. Peter

    CC makes a good point about the cost of your time. Even if you can beat the index, perhaps that 10-15 hours/month spent reading financial reports, forums, and the investor section of the paper could be better spent working overtime, earning a masters/PhD, developing your technical and leadership skills to further advance your career.. All of these things, plus index investing your now-higher salary will probably put you ahead in the end.

    Of course I’m still here… spending (wasting?) my time on forums and blogs ;)

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