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
Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition). To index invest, find an index, find a fund tracking that index, and then find a broker to buy shares in that fund.
What is the main disadvantage of index fund? ›
Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition). To index invest, find an index, find a fund tracking that index, and then find a broker to buy shares in that fund.
What are the risks of index funds? ›
While they offer advantages like lower risk through diversification and long-term solid returns, index funds are also subject to market swings and lack the flexibility of active management.
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.
What are index disadvantages? ›
The first and perhaps most obvious drawback of adding indexes is that they take up additional storage space. The exact amount of space depends on the size of the table and the number of columns in the index, but it's usually a small percentage of the total size of the table.
Why do people not buy 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.
Do billionaires invest in index funds? ›
The bottom line is that even billionaires recognize the wealth-creation potential of low-cost index funds. Even if you're an active investor in individual stocks -- like Buffett and Dalio are -- rock-solid index funds like these four can help form an excellent backbone for your portfolio.
Are index funds safe from inflation? ›
While the stock market might get hit by worries of inflation, the best companies power through it with their better economics. Stick with a well-diversified portfolio, or go with an S&P 500 index fund, for potentially long-term attractive returns that beat out inflation.
Is an S&P index fund risky? ›
The S&P 500 carries market risk, as its value fluctuates with overall market performance, as well as the performance of heavily weighted stocks and sectors.
Should I keep my money in index funds? ›
Index funds often perform better than actively managed funds over the long-term. Index funds are less expensive than actively managed funds. Index funds typically carry less risk than individual stocks.
The S&P 500 is all US-domiciled companies that over the last ~40 years have accounted for ~50% of all global stocks. By just owning the S&P 500 you miss out on almost half of the global opportunity set which is another ~10,000 public companies.
Do index funds beat the market? ›
Index funds seek market-average returns, while active mutual funds try to outperform the market. Active mutual funds typically have higher fees than index funds. Index fund performance is relatively predictable; active mutual fund performance tends to be less so.
Does Warren Buffett believe in index funds? ›
Buffett's rationale behind endorsing S&P 500 index funds is rooted in their simplicity and effectiveness. He argues that attempting to outperform the market is futile for most investors, and instead, they should seek exposure to the broad U.S. stock market through low-cost index funds.
What is better than index funds? ›
Exchange-traded funds (ETFs) and index funds are similar in many ways but ETFs are considered to be more convenient to enter or exit. They can be traded more easily than index funds and traditional mutual funds, similar to how common stocks are traded on a stock exchange.
What are index funds pros and cons? ›
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.
Do index funds lose value? ›
As with all investments, it is possible to lose money in an index fund, but if you invest in an index fund and hold it over the long-term, it is likely that your investment will increase in value over time.
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.
Do index funds ever fail? ›
Much of it, yes, but not entirely. In a broad-based sell-off of a market, the benchmark index will lose value accordingly. That means an index fund tied to the benchmark will also lose value.
