The Ins And Outs of Index Investing

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Men doing index investing

Source: web

When buying shares within an index fund instead of buying mutual fund shares, there is not a lot of research that needs to be done because you are opting to take part in the gains that are earned by all of the companies within the index rather than trying to weed out the winners from the losers. While the time-saving aspect of index investing is a significant perk, it is best to know all of the ins and outs of this type of investing so that you can determine whether or not this is the type of investing for you.

The Ins

1. One of the major advantages of index investing is that it can protect an investor from making major mistakes. While it can be extremely beneficial to extensively research stocks to find which performs better than the typical investment, there is a lot of risk in that. Most individuals simply don’t have the time to engage in extensive research to pick stocks. If they do, then it is easy to miss something very important that could be costly in the end. The typical alternative is to hire an investment firm to assist with the choosing of stocks and the building of a portfolio.

If you do not have the money to hire a broker, index investing can be beneficial although it does not typically earn the highest returns. What it does is permit the investor to earn solid returns without taking excessive risks.

2. Another advantage to index investing is that there are no gimmicks. There are no charts for you to study in order to find success. You don’t have to study patterns so that you can identify what may be a good investment and what may not be. Yes, you may get rich slowly, but it is a common-sense type of investment to make. Some of the more famous names in investing, such as Scott Burns and john Bogle, have stated that you don’t have to try and beat the market in order to do well as an investor; all you have to be is a part of the market.

3. The third benefit of index investing is that the returns are rather consistent. They may not be great, but they are a bit more secure. Just look at this: The annual real return on U.S. stocks is historically closer to 7%. That’s actually a pretty good return. If an investor can score a 7% return without taking a huge risk, then that’s a deal worth taking.

4. The fourth good thing about index investing is that it is a more humble type of investing. Index investors recognize that they can’t outsmart everybody by becoming stock pickers. This means that index investing is the ideal type of investment activity for those who may be emotional when they invest their money. There is a rather peaceful nature to indexes due to the solid nature of their returns, so the fear of being let down is significantly muted.

The Outs

1. The first “out” of index investing is the fact that some index investors lose some of their humbleness. Unfortunately, this is something that can occur rather easily in that it is not hard to believe that the indexing approach is better than the alternatives out there. This leads to pride and, unfortunately, pride comes before failing. Of course, this is an “out” that is dependent upon the individual. If you are always humble about index investing, then you should have no problem remaining successful.

2. The second disadvantage of index investing is that the conventional approach to indexing does not allow consideration for the effects that valuation level changes will have. What you pay for an investment is going to affect the return in the long-term. This is why it does help to look at whether the investment is undervalued, is at fair value, or if it is over-valued. Most index investors do not take valuation into account, but it is actually something that can’t hurt. If you are someone who wants to consider valuation, then conventional index investing may not be the right approach for you. Non-conventional index investing may be.

3. The third con is that the investor may lose sight of the connection between the returns that are received and corporate profits. Corporate profits have a lot to do with the returns because returns just don’t happen all on their own. The companies being invested in have to earn them for the investors. As for the reason why the connection between profits and returns is lost is because index investors don’t have to study the companies within the index, but it is still good to recognize how profits make a difference. This could ultimately have an influence on which index is invested in.

4. If you are the adventurous type, then the fourth con is one that you may agree with. This con involves the rigid and mechanical nature of this type of investing. This is especially true for the conventional investors that do not want to deviate from the old ways. Those that are not mechanical in their investing tend to have more diverse portfolios, while the purists state that it is best to put all money into index investing. The purists will also argue that there is no room for a broker, which may not necessarily be true. Brokers can still have a place with indexing.

5. The fifth con is that index investing tends to be a safe haven for the emotional investor. This tends to affect a person’s desire to be a true buy-and-hold investor. An index investor will tell others that they are a buy-and-hold investor, but they do not always walk the way they talk. The true buy-and-hold index investor will adjust their stock allocation with the valuation levels. The intention is to take this approach, but it does not always happen this way. What many do not realize is that by not taking valuation into consideration, they could be making big bets on high valuations and this can result in devastating losses.

Basically, index investing is a safe type of investing when approached in the right way and it can become a little more exciting and profitable with a small amount of research in regards to valuation. You can choose to enlist the help of a broker or you can go about this type of investment on your own. You have the freedom to choose.

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About Author

Ginger has over a decade of experience in the area of personal finance. She has provided informative content and advice on a number of finance-related topics to individuals in the U.S. and Europe. She is able to do this because of her personal and professional experience, which includes work in the financial sector and 10 years in tax preparation. She resides in Ohio with her husband and three children.


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