What Are Index Funds?

If you are tired of trying to beat the stock market, index investing may be the best solution for you. Index funds work by investing your money into an index of stocks. (You may have heard of S&P 500 or the Dow.) When you put money into an index fund, you are investing in all of the companies that make up that particular index’s portfolio.

This is an alternative to choosing and investing in particular stocks. The same risks exist for you as those who buy stocks individually. However, investing in an index can provide broad diversification for your equity investments. Instead of putting your eggs in a few baskets, you’re putting one egg in 500 baskets (using the S&P 500 as an example).

Pros:  

They are inexpensive

There are usually no hidden fees or sales commissions with index funds. They have low annual fees- much more insignificant than the large fees that hedge funds and other alternatives charge. You can also increase your investments regularly without facing additional charges. Avoid indexes that do charge investors extra.

They Allow You to Invest in A Diverse Selection of Stocks

A well-balanced portfolio is key, and index funds aim to achieve this. As an individual, our investment opportunities are far more limited. By teaming up in an index fund we are able to share in the investments of many different stock companies. This is a much more attainable goal when we are part of an index fund.

They’re Efficient

Index funds financially outperform the majority of mutual funds. Although solo investors enjoy trying to “beat” the stock market and outsmart the institution, research has shown time after time that index fund earnings are much more consistent.

On top of bringing in more earnings, they are also user-friendly and easy. You can link your bank account to the index fund and it will automatically withdraw on a regular basis for you. No work on your part at all! Not only do you avoid having to study the stock market, but you also do not have to move the money over regularly.

It’s A No-Brainer

For anyone who is a newbie when it comes to investing, index funds are a life-saver. You don’t have to pick individual stocks or worry about the market rising and falling. All you have to do is provide the money, and the market should grow over time.

Cons of index investing: 

They Can be Vague

The assets making up a fund’s portfolio are constantly changing. It can be difficult to see exactly what you own and exactly how much you have made by investing. This is due to the fluctuating values in the underlying stocks and the index itself.

Limited Upside

Although investing in individual stocks can be messy and dangerous, some investors have a special eye for it. The professionals can often beat the market and get ahead of the game. In an index fund, you will never beat the market, because you will only grow consistently alongside it.

You’re Not in Charge

If you like to be in control, it could be difficult to learn to trust your money with strangers. Your index fund managers will be the ones in charge of what the fund gains in assets. You will likely never be personally able to call the shots in an index fund, and that is something you will have to come to terms with.

Not Suitable For All Investors

One of the most obvious cons of index investing is the “blanket” suitability for all investors. That’s, simply, not the case. The risk/return relationship suggests that higher return investments usually involve higher risk. Index funds are typically designed to capture the median performance of markets such as the S&P 500 or the Russell 2000.

As a result, they usually return market performance – no more and no less. If you want a very risky investment strategy, say, for example, investing in reverse convertible bonds, you likely won’t find index funds a suitable investment vehicle.

There Can be Fees

Some index funds do charge high fees and commissions. Be sure to stay clear of these.

My Concern

Generally speaking, index funds are great. They offer broad exposure to the market and do an incredible job at limiting fees.

But, in my mind, there are two more cons of index investing:

1. Accidental concentration – As the market ebbs and flows, some sectors and industries will do better than others. For example, over the last 10+ years, the technology sector has outperformed the broader market by a large margin. As a result, tech makes up a greater portion of the index. If that sector experiences a pullback, the index as a whole will fall.
2. Liquidity concerns – This mainly applies to index ETFs, but if the market, as a whole, drops, inexperienced investors will sell out of their positions to limit their losses. When there is a rush for liquidity, these ETFs need to sell underlying positions to provide investors with that liquidity. This can lead to an acceleration of losses. Investors sell, portfolio managers sell to give individuals their money, so underlying assets drop. This can cause more investors to sell, and again, portfolio managers to sell more. It’s a domino effect

Related reading:

Can you afford not to use index funds?

Robo-advisers: What I like and what I don’t like