If you’ve been reading the financial media, you may have heard the term indexing, or index investing, pop up. Despite how often this term is used, I have found that very few people understand what it means. For starters, you can’t invest directly in an index.
This is a discussion of the rise of index funds, seven common mistakes I see investors make, and some considerations for selecting an effective portfolio.
Index funds
An index, by definition, is a list of stocks that act as a sort of indicator of how your portfolio is doing for its investment category. As an example, if you wanted to invest in a portfolio of large company stocks, the index you would likely compare your portfolio to would be the S&P 500, which is a list of the 500 largest publicly traded companies in the United States. United. The largest companies are measured by their market capitalization, which is the number of shares listed on a stock exchange multiplied by the price per share.
The concept of index investing is gaining ground immense popularity recently, but got his start with a man named Jack Bogle in 1951. Jack Bogle, who later founded The Vanguard Group, wrote his thesis at Princeton University, on how active portfolio managers (people who select individual stocks and try to time the market) tend to lose to a simple list of stocks, known as ‘hint. Today, hundreds of funds attempt to imitate indexes by investing in a similar list of stocks.
Common mistakes
Because so many people hear that they should index without understanding what that means, I see a lot of people making similar mistakes.
One and done
If you choose between investing in individual stocks and a single index fund, your risk-adjusted expected returns and diversification will be much higher with a single index fund. However, a single index fund often does not provide complete diversification.
No real diversification
I see so many people just trying to follow the S&P 500, which only tracks large US-based companies. To add diversification, I sometimes see people add an additional index fund to a large company with a different investment manager. They would invest in virtually the same stocks, so you wouldn’t get any significant diversification benefits.
Bigger is better
Many people are surprised to learn that large company indexes have not historically generated the highest returns of any category. Since academics began tracking index returns in 1926, small businesses have actually had higher average yields than large companies by around 2% per year. The Russell 2000 is a popular example of a small company index.
Not considering diversification on an international scale
Investing only in the S&P 500 also ignores the potential benefits of international investing. Many investors are interested in investing in stocks from emerging economies (like India) and developed countries (like Japan). The United States accounts for 70% of the world’s stock market capitalization, while 30% of the market capitalization belongs to other countries. A portfolio diversified globally and in size allows investors to capture returns wherever they occur.
Trying to Time the Market
Lots of research shows that market timing is not effective. Despite this, I see investors trying to time the market every day. If you think index investing is the best way to manage your portfolio, but you opt for cash during a downturn or try to bet on a sector (like energy or technology) that is rising sharply, your portfolio is not passive. and you are not maximizing your potential gain over long periods of time.
Inappropriate risk
Every investor should invest with their goals and risk tolerance in mind. An investor once told me, “I’m a pretty conservative investor, my funds are only in an S&P 500 fund.”
A stock index fund, no matter how diversified, is considered an aggressive investment. An investor in an all-stock portfolio should have a high risk tolerance and a long-term horizon until they have to rely on their investment portfolio for distributions.
Investors who don’t meet this description may want to consider adding fixed income to their portfolio. There are also a wide variety of fixed income index funds that investors have access to.
Failing to rebalance
The indices themselves automatically rebalance based on which companies are added or removed from the given index. However, if you create a portfolio and fail to rebalance it, you may end up over time with a very different portfolio than you originally intended.
Let’s say you’re a moderate investor and today you put yourself in a portfolio that’s 60% stocks and 40% bonds. If you didn’t pay attention for 25 years, you’d probably own a lot more stocks than bonds, because stocks tend to outperform over time. If you hypothetically ended up with 85% stocks and 15% bonds, your portfolio could be exposed to significant risk at an older age, likely much closer to retirement. For this reason, it is important to rebalance your portfolio so that your assets are distributed the way you want.
Conclusion
Investing in index funds involves attempting to imitate a list of stocks within a specific category. Although index funds are a useful tool for investing, it is important to be aware of common mistakes investors make when it comes to investing in index funds. When in doubt, consider speaking with a qualified financial professional about your goals and risk tolerance to effectively allocate your portfolio.
Asset allocation, diversification and rebalancing do not guarantee a profit or protect against losses. This informational and educational article does not offer or constitute, and should not be relied upon as, tax or financial advice. Your unique needs, objectives and circumstances require the individualized attention of your own tax and financial professionals whose advice and services will take precedence over any information provided in this article. Equitable Advisors, LLC and its associates and affiliates do not provide tax or legal advice or services. Equitable Advisors, LLC (Equitable Financial Advisors in MI and TN) and its affiliates do not endorse, endorse, or make any representations as to the accuracy, completeness, or suitability of any portion of any content linked to This item.
Cicely Jones (CA Insurance Lic. #: 0K81625) offers securities through Equitable Advisors, LLC (NY, NY 212-314-4600), member FINRA, SIPC (Equitable Financial Advisors in MI & TN) and offers annuity and insurance products through Equitable. Network, LLC, which does business in California as Equitable Network Insurance Agency of California, LLC). Financial professionals may transact business transactions and/or respond to inquiries only in states in which they are properly qualified. Any compensation Ms. Jones may receive for publication of this article is earned separately and entirely outside of her capacity from Equitable Advisors, LLC and Equitable Network, LLC (Equitable Network Insurance Agency of California, LLC). AGE-6089079.1 (23/11)(Exp. 25/11)