Devil's Advocate 

Don’t Invest in Index Funds

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This is a Devil's Advocate post.

We all know that the best way to take advantage of the tendency of the stock market to gain over time is to invest in index funds, right? It makes sense: You get a share of everything on the index, so as the index rises over time, you see increases in your own holdings. Plus, investing in index funds reduces the need to do tons of research — no worries about stock picking and seeing your choices fail miserably. Unfortunately, investing in index funds may not be your best option. When you really think about it, index funds might not be the way to go at all.

Your Index Fund Could Have You Buying High

If your index fund is weighted according to market capitalization, it could mean that you are actually buying high, rather than buying low. When a company becomes more expensive, due to P/E ratios, the index fund needs to increase the holdings in that company — and sell off a cheaper company to do so. Plus, many indices take a long time to get rid of companies that are losing value. One example is General Motors. The company had a share price of $93 in 2000, and then declined steadily. The company wasn’t kicked off the Dow Jones Industrial Average until 2009 — when the share price had plummeted and GM was on the verge of bankruptcy.

Your investment in index funds could actually have you buying high and selling low, which, as you know, is a terrible investment strategy.

There’s Still Risk Involved

While index funds pushers love to tout their relative safety, it’s important to realize that there is still risk associated with index funds. This means that you could still lose out. If the stock market crashes just before you need your retirement account, stuffed full of index funds, you’re still out of luck. Sure, index funds are likely to be a good bet long term, but a sudden crash just prior to your golden years of retirement will harm you must as much as the next person, and you’ll have to wait for the market to recover before you see some positive movement in your portfolio.

Why Aren’t You Doing Research?

It seems terribly convenient to invest in index funds because you don’t have to do research. However, you should be research most of your investments. Even if you do invest in index funds, you should be researching them. There are different indices, and they have different holdings, as well as different options for your money. You should know what is on any index you invest in.

Plus, once you realize that research can benefit you, it might become more attractive to you to do some research. Finding individual value stocks at bargain prices can be a bonus, and you might discover that you like dividend stocks as well. A little research can go a long way toward helping you build your wealth through investing. Investing in index funds, though, is just an excuse to be lazy when you should be taking an active interest in your investment portfolio.

{ 20 comments, please add your thoughts now! }

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20 Responses to “Don’t Invest in Index Funds”

  1. DIY Investor says:

    “Most investors, both institutional and individual, will find the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.”
    Warren Buffett

    • billsnider says:

      Not true!

      Over the last ten years, most index funds have underperformed general mutual funds.

      Do the research.

      • DIY Investor says:

        The research I’ve seen shows index funds outperforming actively managed funds after fees over long periods of time. I’ll follow Buffett, Makiel, Ellis, Solin, Bogle, Schultheis, Hebner and many. many others on this one.
        I hope you don’t run into a Bill Miller with your retirement funds.
        Good luck!

        • billsnider says:

          Look at the results from the last ten years.

          That is why I live in comfort with an early retirement.

      • tbork84 says:

        I agree with DIY here. From what I have read, once fees are included, mutual funds tend to lag behind over the long term compared to index funds.

        • billsnider says:

          Look at returns for the last ten years.

          • bbb says:

            Why not look at the last year only? or the last five?

            There’s a famous saying in investing which I’ll paraphase: If the actively managed investor gets to pick the time frame, he can always show you that his fund outperformed yours.

            But it doesn’t change the fact that – over the long run, and without biased to time frames – index funds are cleaning actively managed funds’ clocks.

  2. Not all indexes are capitalization weighted, and if you are concerned about buying dogs high then maybe one of them is for your since most alternatives used a fundamentals based weighting. But with these there is no long term evidence that strategy will outperform the overall market.

    The whole purpose of indexing and asset allocation strategies is to manage risk to a level you can live with. No one can eliminate risk on any investment.

    Unless you are a Warren Buffett and you know you are an investment genius, your odds of succeeding at picking individual stocks are low…… there will always be the random successes, but you will never know if their good fortune is just randomness or skill.

  3. You haven’t proposed an alternative and I find your arguments a little weak. Sure index investing isn’t perfect but it’s better than anything else I’ve come across. What do you recommend instead?

    Your first point has some truth to it, but is more of an issue for something like an Index 500 fund. You can sidestep this a bit by using a broader index like a Large Cap Index or even a Total Stock Index.

    Your second point isn’t an indexing issue at all. It’s an issue of asset allocation. Of course there is risk in a stock investment and that’s exactly why most asset allocation models reduce stock exposure as age increases. The real question is: What’s the best way to hold your stock (or bond) position? As I argue below, the best way is to use an index fund.

    Your third point is that we need to do “research.” Agreed, if someone is going to invest they should understand what they’re investing in, but that’s certainly not limited to index investing and shouldn’t be used as a reason not to use index funds. Your argument effectively says: People should research investments. Because people who index tend not to research their index [not sure that’s true], indexing is bad. That’s flawed reasoning at best.

    The reason index investing is superior is because it allows investors broad diversification at an extremely low cost. The low cost element shouldn’t be underestimated– it allows the investor to pocket as much of the market return as possible. That’s an important point when comparing indexing to active strategies. Additionally, indexing is extremely tax efficient. And yes investors should “research” their index, but it takes a lot less time to understand a couple of index funds than it does to analyze 20 different stocks.

  4. Miranda says:

    Ah, that’s why it’s called a Devil’s Advocate post. 😉 We try to see the other side. Because anyone who really knows me, knows that I love me the index funds…But you right that you need to choose index funds carefully.

    • billsnider says:

      Based on what you just said, in the last ten years you have underperformed your potential.

      Bill Snider

  5. Anonymous says:

    I agree with you on 1 thing doing the research. The bigger issue is how you are doing your asset allocation. Youll find that is the biggest difference maker of all.

  6. @ Miranda

    The Devil’s Advocate part didn’t show in google reader and I didn’t notice it when I came out here to comment. I guess I was just too focused on my own rant.

  7. poscogrubb says:

    FYI Bargaineering Blog: There was no text in my RSS feed that indicated that this was a Devil’s Advocate post.

    The “out of luck because of the stock market crash just before you retire” reason is stupid for Devil’s advocate, because that reason applies to EVERY fund based on the stock market, not just index funds.

  8. roommate says:

    Dont buy index fund because the market return from 2000 to 2010 was 0% instead pay off your mortgage and get a guaranteed return of 5% after taxes every year not per decade like stocks.

  9. Glad I saw the devils advocate heading at the beginning. Good point reminding readers that there is no risk free investment. Consider dollar cost averaging to buy more shares when prices are lower and less when they are high.

  10. I think the moral of your story is to always do research, regardless of whether ETFs are the right investment for you.

    Mutual funds are actively managed by a person trying to beat the market, while ETFs are passively managed by replicating a particular benchmark.

    Since you are effectively buying a benchmark, it is critical that you thoroughly understand that benchmark. The benchmark you choose should align with your investment objectives: how much return you’re seeking over a defined time period and what kind of risk you feel comfortable assuming along the way.

    Bottom line: If you’re nearing retirement, don’t choose an ETF that is replicating a volatile or risky benchmark.

  11. Dan says:

    This article has a tone of micro-economic speculation, and not the timeless sensibility of low-fee index fund investing which is being analyzed from a “devils advocate” perspective.

    There are no significant reasons for the average investor to NOT invest in low-fee index funds. This post is going to do inexpewreinced investors (aka 90% of the population) more harm than good.

    All things equal, asset allocation (be it stocks, mutual funds, cash, or bonds or whatever) is the primary determinant of investment income. You decrease your percentage of higher risk investment as you near retirement (but always keep some high risk funds).

    Much of this sensationalist financial pseudo-journalism is going to hurt people as they over-react. Lets try and help people, not make a quick buck on sensational “news articles”…

    here’s my favorite part:
    “Investing in index funds, though, is just an excuse to be lazy when you should be taking an active interest in your investment portfolio.” – nice and objective.

  12. Get a Clue! says:

    Seriously, this is ridiculous. Let me end this debate right here. Google S&P SPIVA report. Best survivorship bias free research on active funds vs. index. Only a fool argues with the data. The end.

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