Is Index Investing All It’s Cracked Up to Be?

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Since Vanguard founder John Bogle introduced the concept of index funds in the 1970s, indexing has been gathering steam as an investing strategy. Today, with the ease of online platforms and robo-advisors, indexing is practically a given for many investors.

Index investing is so popular because it allows you to avoid picking stocks, instead relying on the performance of a wide portion of the market for returns. On top of that, indexing is a low-cost way to enjoy instant diversity in your portfolio. Index funds and index ETFs also charge much lower fees than actively managed funds, and some brokers won’t charge transaction fees when you buy proprietary funds.

It seems like a slam dunk: The benefits of the market in a neat, low-cost package. But is indexing really all it’s cracked up to be? Here are some of the downsides to index investing.

You Run the Risk of Buying High

One of the strategies often used in conjunction with indexing is dollar-cost averaging. With this strategy, you invest the same amount of money regularly, and buy as many shares as possible. Often, investments are automated to a certain day each month. That means that you might be buying during times when share prices are high. You get less for your money.

On the other hand, you do get more shares for your money when dollar-cost averaging takes place when the market is lower. However, because the market tends to rise over time, in general, you continue to buy as shares become more expensive. And being invested in the whole market means that index investors will necessarily be over-invested in whatever portion of the market is overvalued, leaving them particularly vulnerable to a market correction.  

Your best hope is that when it’s time to sell and liquidate as part of your retirement income strategy (or for some other reason), the market is on the upswing.

Lack of Flexibility and Control

Another issue is the lack of flexibility and control. Because index funds shares are determined by what’s held in the index, you don’t get to control what’s in there. If you don’t like a company in the fund, you can’t just take it out of your portfolio. This flexibility extends to other mutual funds as well. An active manager can switch out under-performing assets; that’s not the case with passively-managed index funds.

On top of that, there’s a good chance that you might not even be exercising shareholder rights. If you use index ETFs, there’s an even lower probability. Indexing can lead to a situation in which corporate accountability goes down. Many index investors don’t pay attention to what’s going on with the companies, and might not exercise any rights they do have.

No Potential for Big Gains

When you invest in index funds, you’re not going to beat the market in many cases. While there are some indexes that might outperform, in general, you can’t expect your fund to do more than keep pace with the overall market. Plus, because of fees, your real returns are often just shy of overall market performance.

For returns more likely to beat the market, you might consider value investing in carefully chosen individual stocks, particularly dividend stocks. Additionally, you might be able to see better returns when you look into investing in a business of your own, or growing wealth in other ways. Index investing isn’t the only way to see solid gains over time.

Real estate, commodities, and precious metals can also provide you with opportunities for bigger gains over time, if you know how to trade them. It’s important to be careful with these types of assets, though, since they come with their own risks and can sometimes be just as volatile as stocks.

Index Funds: Still the Easiest Way to Achieve Steady, Solid Gains Over Time

In the end, though, index investing is still the easiest way to grow your wealth solidly over time. Sometimes, when you get too deep into a strategy with your portfolio, you run the risk of making assumptions and you drift into market-timing territory. It’s important to be wary of this. With indexing—combined with dollar-cost averaging—you don’t get caught up in timing the market.

When you index over a period of decades, you are more likely to grow your wealth in a way that helps you reach your goals, even if you won’t see huge market-beating gains. One way to approach investing is to put the bulk of your long-term wealth building into an asset allocation strategy using indexing, and then use a smaller portion of your portfolio for investments that have the potential for higher returns.