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Don’t Just Buy Index Funds

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This is a Devil's Advocate post.

What would you rather do, throw a ball with your kid or pore over balance sheets and income statements? Would you rather listen to a shareholder meeting or go shopping with your friends? How about enjoying a nice night on the town or checking the latest interest rates? Honestly, I’m pretty sure everyone out there would much rather throw a ball, shop, and enjoy a night out over the alternatives in all three cases and that’s what the driving idea behind advice like “just buy an index fund and do something else with your time.” Honestly, it’s really good advice and that’s why I’m tackling it in the latest edition of the Devil’s Advocate. (The Devil’s Advocate series is a series of posts that tries to argue the other side of “conventional wisdom” or common advice)

There are basically two main arguments against just blindly investing through index funds and they are:

  1. Index funds are not without risk.
  2. Even though you may not like it, you really should be spending time on research.

1. Index funds are not without risk.

Oftentimes people believe that by picking an index fund you’re going with a “safe” investment because you’ll get what the market returns, minus fees. You won’t beat it but you won’t lose to it, so it represents really the “best” that you can get with as little risk, and effort, as possible. Now, in the full specrum of investing options, to say that index funds are not risky would be wrong. With an index fund, you’re still talking about investing in stocks, which always comes with risks.

If you choose, say an S&P 500 index fund, you also run into the issue of country-specific risk – the United States. Depending on what you think your asset allocation should be, you should consider an international component because putting everything in the US is just as bad, from an allocation perspective, as putting it all in stocks or bonds or art or real estate. There are also other types of risk to consider, outside of stock market volatility and country-specific risk, and you don’t get protection from those by picking an index fund.

Even though you may not like it, you really should be spending time on research.

The part of the advice pundits give about index funds, where you get to spend no time on your investments and get to spend it on other things, doesn’t sit well with me. Certainly, if you want to spend absolutely zero time on one of the most important decisions in your life, your investments, then an index fund is definitely your best choice. However, should you be spending zero time on that in the first place? Probably not considering how much time you probably spend researching the other less financially important things in your life.

You might like it…

This reason doesn’t fit with the two main reasons why going with all index funds might be a bad idea but it’s definitely a “soft” reason why you should consider life outside of index funds. Part of the fun of investing is learning about companies, learning about industries, and learning about other countries and cultures. At the end of the day, you might read a lot of news articles or annual reports about Company X and decide that investing in them isn’t right for you right now, but you’ve still learned a tremendous amount about how Company X does business, how that industry does business, and it could pay dividends down the road. Along the way, you’ll also learn a lot about investing in general and it will help make you a more well-rounded person from both a financial and cultural perspective. Certainly, if investing is boring to you and you don’t ever want anything to do with an annual report or a balance sheet then slogging through them isn’t right for you.

What do you think? Are these reasons against index funds legit or was it a bunch of crap? Do you have any on your mind that trump these? Please let me know!

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20 Responses to “Don’t Just Buy Index Funds”

  1. Jeremy says:

    This is a great topic, I’m glad you did one on this and you brought up a lot of very important points. Most people are on the index fund bandwagon, and for good reason. They do have a lot of benefits:

    1. Low costs
    2. Instant diversification
    3. Simplicity

    Given the benefits, clearly you can see why they are so highly recommended. But there are faults as well. It isn’t so much with index funds themselves but rather the false sense of knowledge by the investor. As you mentioned, some people will go out and buy one index fund such as an S&P and it will make up 90% of their portfolio. They think “oh I’m fine, historically the market will return 10-11% over the long term and I have invested in 500 different companies”.

    While that may be true, I don’t think that is a very intelligent way to handle your life savings. Yes the odds are in your favor, but just one or two index funds may not be the best way to go. You have to consider domestic and international funds, possibly bond funds, maybe money markets, and possibly specialty sector/industry funds as well. While the S&P is the best representation of the market as a whole it is still quite a narrow piece of the investment world.

    The good news is there are index funds that track virtually every sector and even bonds so you can create a well-balanced portfolio with index funds. The bad news is too many people will simply buy one or two index funds and assume they are fine. While they could be, they could also be missing out on additional gains or wind up with a volatile portfolio with no additional benefits in gains (the efficient frontier… which is a completely separate discussion).

    So index funds are understandably the cornerstone of most portfolios, and if used correctly to create an appropriate asset allocation will be a great low-cost way to invest. Used incorrectly can lead to a lack of diversification and a false sense of security which could make the low costs and simplicity a non-issue.

    That brings me to what you said about doing a little research to understand how your investments work. I don’t think people should spend hours everyday pouring over company reports, but just picking one index for nearly all of your investments just because a talking head on TV or in a magazine said it is the right thing to do isn’t the best idea either. People should have at least a basic understanding of how to create a balanced portfolio and learn how different investments work and play a role in reaching their goals. Again, this can be achieved with using nothing but index funds, but all too often people will sacrifice a little research in order to just buy an index fund and assume they are diversified properly.

    Wow that was a long reply. Anyway my point was basically that just like everything else, index funds are a tool. Tools can help you build something great, but you need to know how to use the tool in order for it to be effective.

  2. samerwriter says:

    Hmm, I don’t buy the argument. I’m a huge fan of index funds, and an even bigger fan of target retirement funds.

    Show me an individual investor who does a better job of managing risk than an index fund, or a basket of index funds, and I’ll show you a glow-in-the-dark pig that does gymnastics.

    I think there are a lot of individual investors who _claim_ to balance their portfolios better than an index fund could. I’ve met some of them. I’ve been one of them. But if you can convince them to be honest about their portfolio, in reality they aren’t as diversified as they should be, they don’t rebalance as much as they should, and they switch funds every 6 months because of a convincing article in SmartMoney magazine.

    Regarding the time spent on research, I think that’s a questionable reason as well. I’m as smart as the next guy, and maybe even smarter than that guy drinking beer over there, but unless I have some special knowledge of a company I’m pretty sure that I won’t be able to glean more information from its annual report or balance sheet than anyone else.

    Besides, even if I could get a slight edge on the market, I’ll happily forego the extra .5% return for 1% lower expenses I’ll get by sticking with a Vanguard Target Retirement fund….

  3. The biggest pro-index issue is that there is such a relatively small number of funds that beat the S&P index.

    You talk about the ease of investing being a negative – as though simplicity means that you do not want to pay attention to your investments. This may be true, but it doesn’t solve the fact that most actively managed funds – and, therefore, most portfolios do not beat the S&P.

    Further, no investment is without risk. Even in an FDIC-insured savings account, you still run some risk with inflation – it is possible that inflation would eat away the bulk of your gains even in your ING or Emigrant account. Still, despite the risk involved, those other investments, over time, do not consistently beat the S&P 500 index.

    I think the one thing you left out is that index investing is just boring! :-)

  4. Jeremy says:

    Travelin’ Man, that brings up a good point about actively managed funds. You’re right, one of the common things you read is that most actively managed funds don’t beat “the market”. While this is true, the main thing to consider is that most funds aren’t trying to mimic or beat the market. If they try to mimic the market, all they are is an index.

    Most mutual funds have a specific investment objective. Large-cap growth, small-cap value, large blend, emerging markets, income, high yield bonds, etc. All of these funds typically focus on one investment style or asset category, which clearly will not beat the market as a whole all the time.

    So I think it is a poor argument to simply say that index funds are better because they often beat actively managed funds because almost all actively managed funds are not meant to be a sole representation for someone’s portfolio, but part of a greater asset allocation. It is really comparing apples to oranges.

    Again, index funds are the best “bang for your buck” core holdings, but still they are simply just one tool in creating a diversified portfolio that minimizes risk and maximizes returns. If someone were to only purchase one fund and rely on that for 30 years of growth, yes they would probably be better off going into an S&P index as opposed to some random large-cap fund or sector fund, but creating an asset mix with various index funds or actively managed funds will likely provide equal returns with reduced volatility, which I think is what people should strive for. Maximum return with the least amount of volatility.

  5. mapgirl says:

    “Show me an individual investor who does a better job of managing risk than an index fund, or a basket of index funds, and I’ll show you a glow-in-the-dark pig that does gymnastics.” – Samerwriter

    GREAT QUOTE! It’s true. Very few CFA’s even beat the market over the long run.

    Jim, I think you do your readers a slight disservice with this post. You don’t present any of the statistical reasons about why index funds are good investments for the lazy. They are very solid investment choices because they involve little trading activity so most fees are low for index based funds. They are Buy & Hold funds, which is how Warren Buffett makes his money. He never sells. The thing also to keep in mind is that over any 20 year period in the market’s history, the market has been the best possible investment, beating out gold, currency, or real estate. (Love Jeremy Siegel’s work here.)

    Now, ask me a question, do I hold indexed funds? Yes I do. But as a novice student of investing, I also know that I’m not into CAPM research to find better investments either. I keep a few different funds in my portfolio with a good chunk of it in an S&P500 index fund. But I also have diversified into an REIT fund, small and mid cap funds, and an international fund to broaden out my risk. I plan to hold onto all of them for a good long time. The reason I have branched out beyond index funds are threefold. 1) I like to spread out my risk over a variety of investments. 2) I think I can beat the market slightly if I have one or two investments that are spectacular. I’m looking for an overall ROI that’s only 1-3% greater than the market, so I don’t need a whole lot of winers, just a few. 3) I like to spread out my risk. While I’m willing to take on a lot of risk with an investment portfolio that is large stock-based, I don’t think it’s wise to put all my faith into the US stock market. It fluctuates, which is why I like to balance my risk out with international funds, etc.

    Let me stress however, that I don’t really do any research. VERY LITTLE. Periodically I look at returns, but rarely do they move me to make a trade or rebalance. Things are just fine.

    Oh wait. I see. I guess I do agree with you Jim. No, you shouldn’t make index funds your only investment.

  6. jim says:

    mapgirl – It’s a devil’s advocate post, which seeks just to shine a light on the reasons why one shouldn’t follow conventional wisdom or common advice. In this case, a lot of folks advise that you should just invest in some index funds and be done with it.

    Personally, I love index funds because they’re cheap, perform well, and they’re low maintenance. Maybe I need to put a devil icon or something… :)

  7. mapgirl says:

    “In this case, a lot of folks advise that you should just invest in some index funds and be done with it.”

    That’s just sheer ineptitude and laziness! GAH! Our generational apathy extends to our finances… Man, what a sorry lot we are.

    (I keep hearing that song from Bye Bye Birdie, “Kids! I don’t know what’s wrong with these kids today!” You know the one.)

  8. CPA1298 says:

    Jim – this one is definately controversial, but I think the Devil’s Advocate position is hard to win. Simply, index funds are the logical choice. I don’t need to list the reasons. If a person did simply invest in the S&P all their lives, they would have low cost exposure to the 500 largest companies in the country, which are diversified internationally due to their global operations. I think the weakness of the Devil’s Advocate position shows how strong indexing really is.

    Good effort. I’m still waiting for the 401(k) Devil’s Advocate :)

  9. Angela says:

    Yep, its kind of a weak position, as even when you’re saying that you shouldn’t just invest in a single index fund, one of the solutions given is to invest in more (different) index funds. So I’m pretty much sold.

    What’s the alternative? an actively managed fund that may or may not produce better returns in the future than the index fund or investing in individual companies/bonds/real estate (being your own fund manager).

  10. jim says:

    I agree Angela, it’s a very weak position, but I believe the points above are still worth keeping in mind. Sometimes with these DA posts, the arguments will be a little tenuous but still worth taking a look at (I hope!).

  11. Ashley Barton says:

    I know this comment will get a fair amount of grief from the indexing crowd, but I always smirk when I hear or read statements like “a majority of mutual funds underperform the market”. Don’t get me wrong, I agree with the facts of the statement, but what bothers me is the implication that majority in this case is something close to 100% which it is not. While the number is on the high side (appx. 80%, I believe), it isn’t too difficult to identify most of these underperforming funds. This statement also indicates that there are 20% of actively managed funds that outperform the market. When I refer to funds that outperform the market, I’m not talking about over the past couple of years, I’m talking about funds who have annualized expense-adjusted returns better than the market for 1, 3, 5 and 10 year time periods and have had the same fund manager for over 10 years. Using the MSN Money Fund Screener, there are 143 no load funds that have outperformed the Vanguard Total Stock Market Index (a better representation of the market than S&P 500) using this criteria, with more than one fund in each of the nine market segments (growth, blend, value & large-cap, mid-cap, small-cap).

    I know there are those who say “past performance doesn’t indicate future returns”, but past performance does indicate future potential. To make an analogy, if I owned a baseball team and were signing a new player and had the choice between the average .275 hitter or a .310 hitter with all other aspects equal, I’d be inclined to sign the .310 hitter. While there is no guarantee that the .310 hitter will continue to bat better than .275, I think his chance are better since he’s shown he can do it in the past. I think the same can be said of mutual fund managers. When you buy a mutual fund you are buying a manager, not a fund name. This is why Janus funds, which did great in the 90′s, have fallen off in the recent past. Most of the managers of the Janus funds in the 90′s have left those funds and either gone elsewhere or started their own fund or fund company.

    Obviously owning an actively managed portfolio requires more work than an index portfolio. I check up on my portfolio quarterly to ensure that my asset allocation is correct, and for any significant changes in my funds progress in relationship with the market. I wouldn’t suggest it to everyone, there is fair amount of diligence involved. Although I think with any portfolio the investor should be diligent. For some reason a lot of investors seem to think the term “buy and hold” really means “buy, hold and forget”. Every investor should be adjusting their asset allocation as it relates to their risk tolerance as time passes. I don’t think anyone would suggest that the asset allocation for someone aged 35 should be identical for someone aged 45 or 50 with like circumstances.

  12. Paul says:

    I think too much attention is paid to investing in stocks. And individual stocks are extremely risky in my opinion. You can as easily end up with a Worldcom or Enron as you do a Microsoft. Unless you are a high roller in the company you invest in, you can never know the true situation. Companies fail at a very high rate. Even great companies like AT&T once was, can go down. For my money, buy an index fund and forget it.

    I’ve written an alternative strategy to investing here
    link

  13. Debt Hater says:

    I love these Devil’s Advocate posts!
    I am not a hard core investor because I still need to get out of debt and I don’t know enough to make smart decisions.
    That said, half of my 401k contributions goes into an S&P 500 index fund and about 30% goes into aggressive international funds. Those are the two best performing components of my 401k so far. I might move more money into the international fund, but I must admit that the index fund makes me feel secure. I feel like I’ll never do worse than the market with the index fund. And yes, I’m too lazy to do much more research than this right now!

  14. Fazal Majid says:

    There is one major problem with index funds: the reason the costs are so low is that fund managers hardly do any work other than periodically reshuffling the portfolio as index composition changes. Among other things, they are not active shareholders. In the best of cases, they will simply vote along with corporate governance advisers like Institutional Shareholder Services.

    Probably one of the biggest downward pressures on returns is the tendency of entrenched managers to loot from shareholders by awarding themselves huge salaries and stock option packages thanks to lax corporate governance. If an when index funds become the majority of holdings, there will be little countervailing force to prevent them from doing so. Not that actively managed mutual funds are any better in this regard.

  15. EF says:

    Good post, but it doesn’t address the main reasons people invest in index funds: they have neither the time or inclination to do research, etc. Plus (apologies for stating the obvious … but it’s often overlooked) NO fund is without risk — every prospectus I’ve ever gotten has said so.

  16. moominoid says:

    I don’t invest in index funds – only use them as trading instruments – ETFs and futures. For people not interested in investing a diversified portfolio of index funds probably makes a lot of sense. For me, this would be way too boring as I love investing and trading. So I’m never going to stick with it.

  17. Indexing is the only investment strategy backed up by 80+ years of research and five nobel prize winners. Specifically, indexing with a heavier weighting on small-caps and value stocks. If you have mined the University of Chicago’s historical data on securities pricing and uncovered an additional factor that explains stock performance, please publish it and claim your own Nobel prize in economics.

  18. Kevin A says:

    Jeremy,
    “Most mutual funds have a specific investment objective. Large-cap growth, small-cap value, large blend, emerging markets, income, high yield bonds, etc. All of these funds typically focus on one investment style or asset category, which clearly will not beat the market as a whole all the time.”
    “So I think it is a poor argument to simply say that index funds are better because they often beat actively managed funds because almost all actively managed funds are not meant to be a sole representation for someone’s portfolio, but part of a greater asset allocation. It is really comparing apples to oranges.”

    I stopped reading arguments after this one, so sorry if someone has already addressed this, but…

    This is a ludacris statement! When you invest, you want to maximize the amount of your return. When you make long term investments, you want to maximize the amount of your long term investment.

    So who cares if your mutual fund has a small-cap growth strategy, or a large-cap value etc. You don’t care what a mutual funds strategy is to make money, you care about how much money it makes!

    Perhaps if there was a way to make things “safer” than the market would you accept a lower return. Whether a mutual fund is really “safer” than the market is at best, AT BEST, questionable.

    So, we are dealing with risk and return. Mutual funds generally have higher risks (Due to less diversification, or, at least less than investing in an entire index of stocks) and lower returns (Due to mangement expenses). They aren’t apples and oranges, it is a fair statement to make say that most mutual funds do not outpreform the market.

  19. The post is a few years old now but the topic is still actual. Just a few thoughts.

    Yes, index investing carries lots of risks, as we could have seen in 2008. It is still investing in the stock market and that one is going up and down.

    But, as commented before by others. Many people do not have the time do the research. The alternative is to do spend a little time on identifying the major turning points in the markets and in this way limiting the risk with index investing. Identifying these turning points is very well possible. You do not need to be exact in it to be able to still step into the market and out of te market at favorable times, e.g. step out in Q4 2007 and step in during Q1 2009.

  20. Actual DA says:

    Very disappointing article, which is nothing more than a thinly-veiled index fund promo. The only cons you see to index funds are “still risky” and “discourage research”? This article might as well have been published by Vanguard.

    Do some real research and figure out what the actual cons are to index funds. Not some flowerly “Index Funds give you too much time to spend with your family” bullet point.


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