Index Fund Investing: Advantages and Disadvantages

Index Fund Investing: Advantages and Disadvantages

Index fund investing has grown in popularity as a passive investment strategy to invest in the market. It is now estimated that almost half of the market is composed of passive investing. With an increasing number of people no longer looking for financial professionals who are unable to consistently beat average market returns, investors are many times choosing index funds.

More investors are starting to realize index funds can be a good low-cost alternative to investing in comparison to hiring a financial advisor with high fees and commissions. Investing in index funds is not perfect. However, there are several advantages with index funds that can often outweigh the disadvantages when it comes to investing.

What is an index fund?

An index fund is a collection of investments that track the performance of a market index, such as the S&P 500 or Dow Jones. Each investment in an index fund contains approximately the same investments as the index it follows. The result is when the index does well in the market the fund itself will do the same.

Index funds may not only track a popular market index, but there are also ones that will be comprised of particular sectors. For example, there could be an investment comprised of only healthcare stocks. Mutual fund index investments are often made of the S&P 500 and are very popular. There might also be ETF’s (Exchange Traded Funds) that will follow sectors or an index.

Because an index fund generally contains an extensive number of investments compared to the index it follows, they offer a good amount of diversification built into them. This is one of the attractions of an index fund. Although investing with index funds does not guarantee success, there are several reasons why they can be a good alternative to picking individual stocks or mutual funds.

What are the advantages of investing in an index fund?

Cost

When it comes to investing nothing comes truly free. There might be no-load mutual funds or commission-free trading options available, but there are almost always expenses associated someplace in an investment. Index funds are no different. Yet, the associated costs of owning an index fund should be low due to their passive investment strategy.

A passive investment is one that does not trade to try and time or beat the market. Each time work needs to be done with an investment there are costs involved. Because an index fund is comprised of investments that follow an index or sector, there is not a lot of trading activity in and out of investments. This is where the passive investment term comes from.

The management fees in an index fund take out less money from an investor’s portfolio to cover the associated costs with buying and selling investments in the fund. The result is more money left in an investor’s portfolio due to a lower expense.

Investing in an index fund should always come with a low cost and this can be a big advantage compared to other options.

Diversification

Having a diversified investment portfolio is essential to limiting exposure to a specific stock or sector in the market. It would be very expensive for an investor to purchase the number of individual investments to track a specific index. For this reason, investing in an index fund can be a good choice. An index fund allows an investor to purchase several different investments at a low price.

There can be a lot of work that goes into picking individual investments to achieve a good level of diversification. With an index fund, the diversification is built-in and there is no need to pick every investment.

Growth

Index investing might not offer the excitement of individual stocks or mutual funds. However, they can offer steady growth. This is especially the case for long-term investors. Because most average investors have a majority of their investment portfolio in retirement savings with a long-term horizon, investing in an index fund can be a good choice.

The S&P 500 has returned about 10% on average over the last 90 years while long-term stock investing can average around 7%-9%. An index fund that even gets a 9% or 10% return over a number of years is not terribly bad considering the low expenses compared to other mutual funds that do not invest in an index.

Because index funds are passively managed, their growth can be quite good for a long-term investment because the costs are lower which can equal a higher return.

Index funds can be a great choice for the average investor

Probably one of the big advantages of an index fund is the benefits for the average investor. They can be a good choice for the buy and hold passive investor that does not want to work with a financial advisor.

Because index funds are low cost and offer good diversification, they can be a beneficial investment for a retirement portfolio and 401k. Index funds are a way for the average investors to diversify their risk at a low cost.

Although index funds most often achieve only an average rate of return, slow and steady growth for reaching a financial retirement goal can be a good thing.

What are the disadvantages of index investing?

Market Swings

Although index investing is generally well-diversified, it is not entirely immune to a market swing or crash. If the market as a whole has a downturn, so will the index. This can be seen when something like a major market downfall occurs and the S&P falls dramatically. If someone owns an index fund that follows the S&P 500, it will fall as well.

Picking individual stocks or mutual funds is generally not as diversified compared to an index. Yet, selecting the right ones could be better in a market swing. Even when there is a major market downturn, there are always certain sectors or investments that will outperform others. Owning an index fund will just follow the overall down market as a whole.

Investment Flexibility

Index funds use a passive investment approach without as much activity comparable to some other investments. Because of this, there isn’t a significant amount of flexibility for the fund manager to trade in and out of investments. This only adds to not being able to possibly limit losses in an overall market downturn or taking a bigger advantage of a market upturn.

An index fund is designed to follow an index. Managers of index funds are required to follow the index they are designed for. This limits possible flexibility.

Because there is not as much flexibility with index investing, it might also be a little more boring to some investors that like the excitement of ups and downs.

Performance

Index investing looks to achieve slow and steady growth. It will follow the average performance of the index it follows. This can limit gains when there is an up or down market. For investors that enjoy trying to time the market and beat it, an index fund is not a good choice.

Index Fund Investing - Passive Slow and Steady Growth Potential

Index investing looks to keep pace with the market. For an investor seeking above-average returns, an index fund is not likely going to work.

Human Interaction

Although a financial advisor’s role is not to achieve above-average performance, most people hire one believing this to be the case. When people primarily use index funds for investing there is no need to have a financial professional because most will not just invest in an index fund for a client.

An investor that will be only investing in an index doesn’t really need a financial professional to make investment decisions and pick individual stocks or mutual funds. For someone that enjoys the interaction with a financial professional, investing in an index fund would not be a good option.

Is index investing a good choice?

Deciding to invest in index funds really depends on what an investor is looking to get out of their investments. Also, it will depend on an investor’s tolerance for risk.

My opinion on index investing is that it is a good choice for most people due to the low costs and diversification. Also, for average investors that do not have the money to get the true value from a financial professional will benefit by investing in index funds. Most people do not have the time or money to successfully pick individual stocks or mutual funds and have them perform better than the market. Furthermore, most financial professionals will also not beat the market year after year.

There are numerous financial professionals that would argue against investing in index funds. Most of them would be financial advisors and money managers. There is a reason most of these people argue against index funds. It’s because index investing does not help them earn a living. Financial professionals like to claim they can do better than most investors will on their own when it comes to investing, but this is generally not the case.

Overall the arguments to index investing really do seem to be in favor of the positive aspects outweighing any negatives and there are several reasons why.

Financial Advisors Don’t Generally Beat the Market

Most financial professionals against index funds will claim investors can do better than average performance when they work with an advisor. However, the truth is most financial professionals do not beat average market returns. Furthermore, actively managed funds themselves often fail to beat their comparative market benchmark over a longer investment time period, according to a recent Morningstar study on active versus passive management fund performance

Sure, there are some really good financial professionals that can beat market averages. But the number of them is much less than most people in the industry would like to admit. An advisor that has a history of above-market returns will more often have up and down years with the long-term average matching a market index or even worse with fees added into the figure. 

For most investors that can achieve above-average returns year after year, it is often because they are invested with something not available to the general public. For example, wealthy investors that gain access to the hedge fund world are many times able to receive investment returns that are much better than the general public. 

What is a hedge fund?

A hedge fund is similar to a mutual fund, but on a bigger level for only very wealthy investors. Hedge funds claim to take on more aggressive and sophisticated methods of investing to provide above-average returns for their clients. This might be the case. However, there might also be more involved many times that most average investors will not have access to. 

Insider trading activity is technically illegal. Yet, don’t think it does not occur every day. The hedge fund world would not be exempt from the practice. There is even a good book on this subject, Circle of Friends: The Massive Federal Crackdown on Insider Trading—and Why the Markets Always Work Against the Little Guy .

Not all wealthy investors in the hedge fund world are getting the advantage of inside information, but they’re certainly some that are rewarded through news not available to the public. More will likely just be on the receiving end of public information much faster than the rest of the investing public. This allows hedge fund managers to quickly take advantage of this knowledge for their benefit. 

The point with hedge funds is most financial professionals do not belong to one. Furthermore, most financial professionals do not have an edge. This does not necessarily mean gaining an advantage with inside information, but being in the right circle of people to act much faster than everyone else. For this reason, most financial advisors are not able to beat market averages consistently. The same is said for most investors. They too will not have the access the ultra-wealthy get.

Hedge funds historically over long investing periods do not even beat market averages in many instances. However, they do offer more flexibility when compared to an index fund to take advantage of market fluctuations.

Average Investors: Index Investing

The truth is most average investors will not have an edge with a financial professional when it comes to returns. The real value most financial advisors bring is not in investment performance, but with more complex investment diversification and tax savings. The kind of services mostly more wealthy investors need. 

There is a reason average investors do not often require the help of a financial advisor. It is because the average investor will generally not be able to get their money’s worth. An average investor that hires a financial professional will many times only be paying to have that person chose investments for them. Buying an index fund is a simple low-cost way to invest without hiring a financial professional. 

I am not saying everyone shouldn’t use a financial advisor, but most people would many times be better educating themselves and investing in something like an index fund. Here is a previous article I even wrote on the subject Does Everyone Need a Financial Advisor?

Warren Buffet, one of the most successful value investors, has even previously commented on how he believes the everyday investor can benefit from index investing.  

Final Word

Index investing can be a great choice for most everyday investors. The low-cost passive investment strategy they use is not exiting. However, investing in an index has shown to provide consistent average market returns. This is particularly the case with a long investment time horizon.

Since most average investors have a majority of their holdings in retirement with something like an IRA or 401k, these typically have a long-term investment time. Using index funds can be a good choice to achieve long-term savings goals and reaching retirement.

Some people can beat market averages and index fund investing. But these individuals are not as common as most financial professionals would like to admit. The financial advisors that do beat the market will typically not do it year after year. Also, with fees and commissions added higher returns could even potentially be less than a comparable index.

Average everyday investors will just not have access to the types of financial professionals that could potentially beat market averages repeatedly year after year. Only wealthy and powerful investors will always have the advantage of their access to information. 

If you are someone that has a financial advisor, there is nothing wrong with this. However, you need to know their role is not likely going to be primarily to attain above-average returns. They will be working to help you reach your financial goals and they won’t be doing it for free. At the very least, ensure your advisor is at least matching a comparable index after fees and expenses. If they are not, you might be better off just investing in an index fund on your own.

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