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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.

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FrugalTrader About the author: FrugalTrader is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 56 comments… add one }

  • David V September 16, 2008, 5:38 pm

    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?

  • Start-Up September 16, 2008, 5:51 pm

    @ 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.

  • MoneyEnergy June 1, 2009, 4:53 am

    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.

  • Eric November 15, 2009, 11:03 pm

    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/

  • Ray July 17, 2010, 10:39 pm

    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.

  • Peter December 2, 2010, 2:22 am

    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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