Market index funds became very popular in the later years of the 90s bull market. These funds do well in bull markets and provide a low cost vehicle for passive investing. These facts have made index investing one of the most popular choices of investors, and certainly the most touted strategy of the financial media. Whether or not you want to include market index funds in your asset allocation is a decision every investor has to make.
But does this make market index funds the right choice?
What is a Market Index Fund?
An index fund is usually an exchange traded fund (ETF) or mutual fund which tracks a specific index. A market index fund tracks a broad market index such as the S&P 500 and is considered a passive form of investing versus active investing.
The advantages of investing in index funds are lower expense ratios and instant diversification. With the addition of hundreds of new ETFs, which track specific sectors or sub-sectors of the market, these index funds can even be used for immediate diversification in a specific slice of the market.
There is a time and place for index funds within a portfolio. Making index funds a part of your portfolio can provide added diversification and profits to your portfolio when done properly. But investors who purchase market index funds exclusively guarantee a mediocre performance for their portfolio.
Disadvantages of Index Funds
Index funds have two damaging long term flaws. These flaws should cause investors to pause and consider whether index funds, and especially market index funds, are the best choice for their portfolio.
1. Index Funds Hold Overpriced Stocks
Indexes are inherently skewed towards stocks that have done well and may be overpriced. As a stock rises it becomes a larger percentage of that particular index. The reverse also holds true. Stocks that have performed poorly, and may be underpriced, become a smaller percentage of a particular index. Therefore, when you own an index fund you own a bigger percentage of stocks that have done well, and less of stocks that may be bargains and have greater potential for doing well in the future.
2. Over Diversification
Over diversification can be almost as dangerous as under diversification. Market index funds take diversification to an extreme. Instead of owning 20-40 stocks, which most financial analysts believe is sufficient diversification, they own hundreds, and some thousands, of stocks.
A broad based market index fund is by definition going to provide average or market rates of return, but no better. This means long term bear markets, such as we are currently experiencing, can destroy long term investment returns.
A Better Alternative: Individual Stocks and ETFs
A passive strategy using market index funds does not work well in flat or bear markets. This was evident to investors who bought into passive investing, and from 2000 – 2009, they experienced very poor returns.
Proper diversification and low fees can be achieved through owning a reasonable number of individual stocks and low cost exchange traded funds. This strategy avoids the pitfalls of holding over priced stocks and over diversification.
Your investment portfolio is one of the most important financial endeavors of your lifetime. Is it not worthy of the extra effort to own the best stocks and ETFs, or do you want to settle for average returns?
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