There has been a lot of buzz lately about indexing, and for good reason. Statistics show that many actively managed investments don’t beat their benchmarks.1 So, should we all invest solely in indexes? To answer this question, let’s look under the hood to get a deeper understanding.
Let’s say that the U.S. economy is like an engine made up of 500 parts. Each part is important and together they create motion, either forwards or backwards.
The S&P 500 is most widely regarded as the engine of the of the U.S. economy. This engine is made up of 500 stocks like GE, IBM, Apple, and Chevron. If most of these stocks are heading up, the economy is moving forward. The converse is also true.
For most people it would be too complicated to go out and buy 500 parts and build an engine from scratch. We go to a dealership to buy a whole engine already assembled.
The investment challenge is that buying all 500 stocks in the exact quantity of the index is impractical for most and one cannot buy an index directly. An index investment can assemble one portfolio that resembles the 500 parts of the index.
When you buy an index fund you usually get several important benefits such as clear goals, diversification, and reasonable fees.
The objective and implementation should be clear. One does not have to spend hours researching prospectuses to determine exactly what is being held.
When buying an engine, one gets the parts. This diversification reduces your risk because if one stock drops another may do better. With diversification there is a better chance of making money over long periods of time.
Passive investing requires little tinkering under the hood. This helps keep fees reasonable.
Like any investment there are drawbacks: risk, investor behavior, and inefficient markets.
Index investments behave almost exactly like their indexes. This seems so simple that it shouldn’t need mentioning. However, many people only look at the potential return without contemplating the risk.
A good illustration is the “Great Recession” when the S&P 500 went down by 57 percent from October 2007 to March 2009. People indexing only in the S&P 500 lost over half of their 401(k) and couldn’t retire as planned. This greatly impacted people planning to retire who were taking too much risk.
Research shows that individual stock investors have significantly underperformed the S&P 500.2 This is mostly due to investors buying and selling at the wrong time. Just holding an index investment does little to solve this problem and accomplish your goals.
Indexing works best where markets and information are efficient. However, many investors believe that when searching for worthwhile opportunities in other places where information is scarce, it may be worth it to hire an expert to gather more information.
Indexing has become popular and new indexes are introduced all of the time. Not only can you find indexes tracking “the market” but also segments of the market like tech stocks, international markets, and even commodities like oil.
The success of indexing might also be its downfall. “Investing theories run in cycles. A success becomes a fad and a fad becomes a failure. Smart people bet against fads.”3
One must ever be on the watch to ensure they aren’t just following a fad, but that they are using a strong investment strategy built for the current market environment and their own risk tolerance.
What do you do if your engine isn’t working perfectly or you want some improvements? You can either do it yourself or go to a mechanic. In the investing world, the mechanic is an active manager. That active manager is going to replace the parts he/she thinks are hindering performance with other parts designed to boost performance.
Smedley Financial specializes in designing efficient portfolios for the current market environment. We don’t just build engines, we build cars. We typically use indexing to be the engine of a portfolio but then we use other investments to build the remainder of the car.
If you would like to know if your engine is tuned correctly and your car is ready for the road ahead, please contact us for a free review.
- “The Case for Index-Fund Investing,” Vanguard, March 2015. https://personal.vanguard.com/pdf/s296.pdf
- Dalbar Study
- “Is Vanguard Too Successful?” Forbes, January 21, 2015.