If you’ve consumed any financial media, you might have heard the terms indexing, or index investing, come up. Despite how frequently they are used, I have found that very few people understand what the terms mean. For starters, you can’t invest directly in an index.
This is a discussion about the rise of index funds, seven common errors I see investors make, and some considerations to select an effective portfolio.
Index Funds
An index, by definition, is a list of stocks that acts as a sort of measuring stick for how your portfolio is doing in its investment category. For example, if you want to invest in a portfolio of large company stocks, the index you’d compare your portfolio with would likely be the S&P 500. This is a list of the 500 largest publicly traded U.S. companies and they are measured by market capitalization, which is the number of shares that are publicly traded multiplied by the price per share.
The concept of index investing has been gaining immense popularity recently, but it was started by a man named Jack Bogle in 1951. Bogle, who later founded The Vanguard Group, wrote his thesis at Princeton University about how active portfolio managers (people who select individual stocks and attempt to time the market) tend to lose to a simple list of stocks, known as an index. Today, hundreds of funds attempt to mimic indexes by investing in a similar list of stocks.
Common Investing Errors
Because investors often hear that they should be indexing without understanding what it means, I see a lot of people making similar mistakes.
One And Done
If you’re choosing between investing in individual stocks and a single index fund, your risk-adjusted expected returns and diversification will be much higher with a single index fund. However, a single index fund often does not provide complete diversification.
Not Really Diversifying
So many people just try to track the S&P 500, which only includes large companies based in the United States. To add diversification, I sometimes see people layer on an additional large company index fund with a different investment manager. They invest in virtually the same stocks, which does not result in significant diversification benefits.
Thinking Bigger Is Better
Many people are surprised to learn that large company indexes have not historically had the highest returns out of all categories. Since academics started tracking index returns in 1926, small companies have, in fact, had higher average returns than large companies by about 2% per year. The Russell 2000 is a popular example of a small company index.
Failing To Consider International Diversification
Investing in just the S&P 500 also disregards the potential benefits of investing internationally. Many investors gain from investing in stocks of both emerging economies (like India) and developed nations (like Japan). The United States makes up 70% of the world’s market capitalization, while 30% lies with other countries. A global and size-diversified portfolio allows investors to capture returns wherever they occur.
Trying To Time The Market
There is a lot of research, including by Nobel Prize winner Eugene Fama, showing that timing the market is not effective. Despite this, I see investors attempt to do so every day. If you’re someone who believes that index investing is the best way to operate your portfolio, but you move to cash in a downturn or try to bet on a sector (such as energy or tech) going way up, your portfolio is not passive and you’re not maximizing your potential gain over long periods of time.
Inappropriate Risk
Every investor should be making financial decisions with their goals and tolerance for risk in mind. A person I worked with once told me, “I’m a pretty conservative investor, my funds are just in an S&P 500 fund.”
A stock-based index fund, no matter how well diversified, is considered an aggressive investment. Investors in an all-stock portfolio should have a high tolerance for risk and a long-time horizon until they need to rely on their investment portfolio for distributions.
Investors who don’t meet this description may consider adding fixed income to their portfolio. There is a wide variety of such index funds that you have access to as well.
Failing To Rebalance
Indexes themselves rebalance automatically according to which companies are added to or taken out of the given index. However, if you create a portfolio and fail to rebalance it, you’re likely to end up with a much different portfolio over time than you originally intended.
Let’s say you are a moderate investor and today, you put yourself in a portfolio that is 60% stocks and 40% bonds. If you didn’t look at it for 25 years, you would likely have much more money in stocks than bonds because stocks tend to outperform over time. If you had hypothetically ended up with 85% in stocks and 15% in bonds, your portfolio might be at significant risk in older age, when you are likely much closer to retirement. For this reason, it’s important to rebalance your portfolio and to keep your assets allocated in the way you intended.
Conclusion
Investing in index funds involves an attempt to mimic a list of stocks within a specific category. While they are a useful investing tool, it’s important to be aware of these common errors investors make with investing in index funds. When in doubt, consider speaking with a qualified financial professional about your goals and risk tolerance to allocate your portfolio effectively.
Asset allocation, diversification and rebalancing do not guarantee a profit or protection against loss. This informational and educational article does not offer or constitute, and should not be relied upon as, tax or financial advice. Your unique needs, goals and circumstances require the individualized attention of your own tax and financial professionals whose advice and services will prevail over any information provided in this article. Equitable Advisors, LLC and its associates and affiliates do not provide tax or legal advice or services. Equitable Advisors, LLC (Equitable Financial Advisors in MI and TN) and its affiliates do not endorse, approve or make any representations as to the accuracy, completeness or appropriateness of any part of any content linked to from this article.
Cicely Jones (CA Insurance Lic. #: 0K81625) offers securities through Equitable Advisors, LLC (NY, NY 212-314-4600), member FINRA, SIPC (Equitable Financial Advisors in MI & TN) and offers annuity and insurance products through Equitable Network, LLC, which conducts business in California as Equitable Network Insurance Agency of California, LLC). Financial Professionals may transact business and/or respond to inquiries only in state(s) in which they are properly qualified. Any compensation that Ms. Jones may receive for the publication of this article is earned separate from, and entirely outside of her capacities with, Equitable Advisors, LLC and Equitable Network, LLC (Equitable Network Insurance Agency of California, LLC). AGE-6089079.1 (11/23)(Exp. 11/25)
Read the full article here