- I’ll discuss 5 things everyone who’s thinking about investing or has invested in index funds should know.
- There’s only one way to properly invest in index funds, but few investors are able to stick to the strategy for a long time.
- Index investing isn’t the cure-all, and proper portfolio allocation should be always applied.
The predominant investing strategy right now is to invest in index funds which means that you own an index like the S&P 500, which is a basket of the 500 biggest businesses traded in the U.S.
Owning part of the 500 biggest businesses in the U.S. isn’t a bad thing, but there are a few things you should know before allocating your hard-earned money to index funds.
Investing In Index Funds Is Extremely Risky
You’ve probably read that many, even Warren Buffett, says that investing in index funds is the best way to invest. However, there are many catches that go along that statement.
The first thing many forget to talk about is the risk of investing in index funds. The S&P 500 dropped 49% in 2001, and 57% in 2009. Such huge drops are extremely indicative of what can happen, and such drops will certainly happen again sometime in the future.
In both cases, the S&P 500 recovered but there is absolutely no guarantee that it will do so after the next drop. For example, after the 1920s bull market, it took the S&P 500 25 years to return to the previous level.
There are also many periods of more than 10 years where stock market returns haven’t been positive. From 2000 to 2013, and from 1968 to 1982 are two examples. If we adjust the returns for inflation, the periods where the actual return is zero are even longer: 2000 to 2016, 1966 to 1994. What’s also staggering is that from 1927 to 1982, inflation adjusted stock market returns have been negative.
There’s only one way to properly invest in index funds and it’s a good strategy if you can stick to it your whole life.
If you dollar cost average your investments into index funds, you will do fine over the very long term. Dollar cost averaging means that you invest a fixed amount every month no matter what’s going on in the market. This way, you invest when things do well but also when things don’t do that well, which is the key. If you look back to the above chart, those who invested in 1931, 1940, 1982, and 2009 have reaped the best investing returns. As it’s impossible to time the market, dollar cost averaging is the only way to properly invest in index funds. However, few have the discipline to do so over the long term.
A dollar cost averaging strategy works only if you keep investing when things are rough. This means that it’s essential to invest when there is blood in the streets, meaning when most investors are selling in a panic over what might happen next and no one wants any kind of association with stocks. Such a situation happened in 2001 and 2009. Those who’ve invested in stocks month after month for the last 10 or 20 years have done well.
However, if you stop investing during recessions because you prefer to save cash in case you lose your job, then you should avoid index investing completely because it’s extremely risky if you don’t dollar cost average and will lead to bad returns.
As simple as a dollar cost averaging strategy may sound, very few are able to stick to it. The result is that the average investor return over the last 20 years has been 2.3%, while the market returned 7.7% per year on average.
Where did the 5.4% yearly difference go? Well, it was eaten up by fees and by the fact that most investors invested in stocks at the wrong time and sold at the wrong time as well. Most investors buy high and sell low.
Therefore, it’s extremely important to understand that investing in index funds works only if you stick to such an investment strategy for 40 years and add money month after month and reinvest the dividends without exception. The sad part is that very few will manage to apply such a strategy throughout their life and that’s something you should see if you can do. If you can’t invest when the stock market is down—or even worse, have to pull your funds out of the stock market when there is a crash,—index investing certainly isn’t for you.
Dividends Are Extremely Low
As shown in figure 3, inflation adjusted stock market returns aren’t that stellar. Over the last 90 years, they have been just shy of 2% per year. The biggest benefit from investing in the stock market in the last 90 years has come from dividends. The problem is that those dividends are at historical lows now.
The low dividends and high current market valuations tell us that we really can’t expect high future returns from the stock market. If you are happy with a 4% return over the very long term, I’m talking 40 years here, then it’s ok. If that 4% return with 50% to 70% downside risk doesn’t fit your investment and retirement goals, then you should avoid index investing. There are better investing strategies out that that will give you higher dividends with perhaps even less risk.
Use Vanguard Funds, Not ETFs
The latest investing craze, apart from Bitcoin, is related to ETFs (exchange traded funds).
ETFs allow you to own an index fund, but also to trade it as a stock on the stock market. The mere trading possibility defeats the purpose of passively investing in an index fund.
As I said above, the only way to properly invest in index funds is by dollar cost averaging through time, reinvesting the dividends, and being patient over a very long period of more than a few decades. Thus the best way to go is to invest through a real low-cost fund where there are no trading and reinvestment costs attached, like a Vanguard S&P 400 fund.
Index Funds Are A New Product
Another interesting thing that many forget is that index funds are relatively new. Vanguard started the index revolution in 1976. It took a while for it to get traction, but index funds eventually became the most used investing vehicle. Did they become the most used vehicle because of their quality or because the stock market has gone up significantly since 1982?
I wonder if index funds will have the same success if the stock market delivers negative returns in the next 10 years.
Remember, over the long term, the wealth created by the stock market comes from dividends and the fact that owning assets protects you from inflation. Returns have nothing to do with index funds and their current popularity.
Index Funds Don’t Give You Proper Diversification
By investing in index funds, you simply aren’t properly diversified.
The top 10 stocks of the S&P 500 make up 20% of the whole index because the index is formed by market capitalization, where the bigger the company is, the bigger its share in the index is. Having 20% of your wealth in 10 stocks isn’t really the best diversification strategy. On top of it, you aren’t diversified internationally and five of the top 10 S&P 500 holdings are in the information technology sector.
Proper diversification should include multiple sectors, commodities, real estate, bonds, gold investments, emerging market investments, debt, private equity, and other vehicles. This is something the S&P 500 doesn’t even come close to, but many put their financial futures in index funds regardless.
I’ve seen many discussions about index investing that completely miss the point of index investing. For example, if you invest in index funds through you banker, your banker will get a fee which is stupid as you can do it by yourself in a few minutes with an online fund and pay absolutely no fee.
Secondly, only a dollar cost averaging strategy—and only if it’s part of a well-diversified portfolio—should be used when investing in index funds. Any other kind of investing will lead to a painful future which isn’t something you want to realize 20 or 30 years from now because you won’t be able to go back in time and fix it.
Keep reading Investiv Daily as I’m always discussing investing strategies that lead to proper diversification and satisfying returns with minimal risk over the long term.