FREE NEWSLETTER
INDEXING IS A GREAT strategy—and yet there’s also a constant temptation to stray.
When stocks soar, so does our self-confidence, as we attribute our investment gains to our own brilliance. At such times, there’s a risk that even hardcore indexers will start dabbling in individual stocks, actively managed funds, cryptocurrencies and goodness knows what else. Meanwhile, amid market slumps, index funds suffer just as much as the market averages, and some indexers may look to sidestep the pain—by “temporarily” abandoning their funds.
Tempted to give up on or lighten up on broad market index funds? Let’s not forget the virtues of what we already own. Here are six reasons to stay the course:
1. Less time. Other than adding new savings and rebalancing occasionally, a portfolio of broad market index funds involves very little upkeep. That frees up time to focus on improving other areas of our financial life, including reducing taxes, minimizing borrowing costs, planning our estate, getting the right insurance and spending thoughtfully. These are all areas where a little effort can deliver big benefits.
2. Less worry. Sure, with an index-fund portfolio, we’re at the mercy of the financial markets. But at least we don’t have to worry about whether the investments we pick will underperform the market averages. Index funds offer relative certainty: Whatever the markets deliver, we indexers know that’s what we’ll get.
3. Tax efficiency. Pursuing active investment strategies in a regular taxable account often leads to big tax bills. That isn’t something indexers need to worry about, because broad market index funds have tiny portfolio turnover, which means they’re slow to realize capital gains. Because of the way shares are created and redeemed, exchange-traded index funds can be especially tax-efficient.
4. Lower costs. Investors collectively earn the markets’ results—before investment expenses. After costs, they inevitably earn less.
Index funds get their edge by mimicking the market averages while minimizing costs. What about active investors? Whether they’re picking individual stocks or buying actively managed funds, the odds are they’ll end up lagging behind the market averages, thanks to the higher costs they incur.
5. Winners included. Almost every year, the market averages are skewed higher—or prevented from falling even more steeply—by a minority of stocks with huge gains. If we try to pick the big winners, we’ll most likely fail. If we buy broad market index funds, we’re guaranteed to own them.
6. Free ride. The financial talking heads—who are almost always proponents of active management—will claim that index funds are distorting market prices or are dangerously overweighted in certain stocks. But the fact is, if we own market-capitalization-weighted index funds, we own exactly the same stocks that active investors collectively own in exactly the same proportions.
The only difference: We didn’t waste time and money trying to figure out which stocks were the best value. Plenty of others remain happy to do so, and we thank them for sacrificing their time and money to keep the markets efficient.
Dear Richard,
Fully agree with your points and I would suggest you add one more: “Lossers excluded” as we consider the mechanic to include/exclude companies from time to time
Best,
Cesar Bardaji
My problem with indexing is the inverse of numbers 2 & 5. Yes, you get 100% of the winners, but you also get 100% of losers. And, the net result is by definition average. I’ve found that I can beat the market on average by avoiding the biggest losers (e.g. tech stocks in 2000 & bank stocks in 2008) and by buying solid straightforward dividend paying stocks.
I also worry less (#2) under this approach because I don’t feel like I’m at the mercy of the market. As long as my companies are building value the short term price doesn’t matter to me.
Also, #3 isn’t relevant for me because I only invest in tax deferred accounts and my costs (#4) are essentially zero nowadays.
Nevertheless, I agree that index funds are the sensible choice.
I’ve read that stock market winners outperform to a greater extent than the losers underperform. If so, it would appear that index performance is not average, but actually above average.
Besides, if index performance were average, you’d expect about half of active managers to beat the index each year. S&P’s SPIVA study has shown, and continues to show, that that’s not the case.