Rarely a day goes by without someone endorsing the wisdom of investing in index funds. And the more this mantra is repeated, the more we see misapplication and frustration from investors attempting to follow this advice. Although index funds are easy to understand conceptually, successfully building portfolios with them can be complex. And while they can be an efficient tool, index funds are no cure for cancer.
Avoid Common Mistakes
Most investors fail to understand that though index funds can offer low cost and efficient access to assets, they’re not a “one-size-fits-all” solution and require the same discipline needed for managing a portfolio with individual securities.
Major brokerages offer more than 60 different index funds. But before ordering off the menu, it’s important to answer some basic questions. First, what is your time frame? If you need money to pay for a car next year, it’s ridiculous to invest in a stock market index fund because the short-term results will be random and potentially volatile. Whether you own individual stocks or stocks in a fund, your need to have a time frame of 10-plus years.
Index fund disciples often forget that when the stock market drops by 60%, that fund will go down with it. During a strong bull market (like the last nine years), it’s easy to forget that the S&P index went nowhere from 2000 to 2009.
Therefore, it’s important for index investors to embrace market volatility - not insulate themselves from it.
Another common mistake investors make is jumping in and out of investments. Discipline is key. You have to be able to stick to the plan when things get rough. This concept has been well-documented by DALBAR studies, which show that the average investor underperforms the stock market indexes by more than 70% over extended periods of time. It’s necessary to stay consistently invested in order to achieve long-term market performance.
If you decide to own an index fund specializing in one area such as healthcare or energy, you’d better be one of the world’s leading authorities on valuing assets in that industry. Otherwise, you have no business chasing after sectors. It’s nothing but gambling.
Ask the Right Questions
A fundamental understanding of how to value assets and markets is quite helpful for investors. Whether buying a new car, a house or an index fund, it’s important to know what you’re getting in return.
Is it a good deal or not? How do you know?
If you’re interested in index funds, ask yourself: Do you want exposure to stocks, fixed income, real estate or some other specialty asset class? If you desire exposure to stocks, do you want domestic, foreign or emerging market assets? Do you want exposure to large, medium or small companies?
Once these questions are answered, investors must identify if they want an index weighted by market capitalization, an equal weighting to all securities, or by some valuation criteria.
A similar process is necessary for investing in fixed income indexes. Do you want domestic, foreign or emerging market assets? Do you want high quality or low quality? Do you want short, medium or long maturities?
In answering these questions, an investor should understand that index funds can offer low cost and efficient access to specific markets. However, tremendous care and consideration must still be applied to selecting the indexes you wish to track. You must then have the appropriate time frame, goals and emotional stability to see the plan through to fruition.