Index Investing

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Index investing is a good one-size-fits-all strategy for the vast majority of people. It is among the simplest ways to manage your assets and widely available in pension plans. It is easy to dollar cost average into with automatic paycheck withdrawals.

Fundamentally it consists of selecting several asset classes, determining how you want to divide your capital between them, buying index funds that track those asset classes as broadly as possible, and then rebalancing occasionally to stick to your chosen allocation. It is typically understood to include large stock and bond components, and occasionally other types of assets as well.

Income can be produced in two ways. Many asset classes have distributions such a dividends or interest that produce fairly regular cashflow. In addition, asset classes tend to have rising prices over time so that you can sell off some of your investments for income, and your portfolio will continue to grow as long as the amount you sell is less than the sustainable increase in price.

Indexing has some fees involved, primarily trading fees if you use ETFs and the actual management fees on the funds which always apply. Since an index portfolio can be assembled with 1-3 ETFs, the trading costs can be very low. In comparison, a portfolio of individual securities that are never or rarely traded or are held by a broker that offers free trades has no fees at all.

Pros:

  • Indexed portfolio can be set up and maintained with very little time and even ignored for years. There are few if any investments that score better on this factor.
  • There is no need to research individual stocks.
  • Their returns are better than randomly chosen mutual funds after adjusting for fees.
  • The fees are almost always lower than a given mutual fund.
  • With only a handful of purchases you can have a strong portfolio.
  • You’ll never “look bad” in front of others because you will always be average. Note: This is very important to some personality types.
  • Based on academic research, namely modern portfolio theory and the efficient market hypothesis which says it's impossible to beat the market because all available information is already priced into individual securities which consequentially have the correct price at all times.
  • Works well with dollar cost averaging because if you have enough time (longer than a market cycle of 10+ years) you will get averaged market timing and averaged risk adjusted returns.
  • Can be combined easily with many other strategies, creating a hybrid strategy. For example the permanent portfolio can be implemented solely using index funds in many countries. Another example is DGI investing, you can buy funds that index the S&P dividend aristocrats and pay a low fee to get the diversification and re-balancing.


Cons:

  • Indexes deliver the average. It's true that it is hard to do better, but if you understand a particular form of investment better than 99% of the participants in the market you may do better by focusing on actively managing that.
  • While the market knows all the available information, investors will not interpret it in the same way. People change their minds and as they change their minds the price changes. Psychology may become dominant leading to trends and bubbles.
  • Unlike individual securities which can be held free of cost, index funds and ETFs incur a low annual fee.
  • When you buy the index you are forced to buy all its components according to their weighting. If you have a strong objection to some of those components and their weighting is significant, this may not be suitable to you.
  • If you already hold more than some 20 individual securities, the additional diversification gained in a broad market stock fund is quite small.
  • You may need to learn about several different asset classes and what types of market cycles they go through in order to manage your asset allocation correctly.
  • Each index fund is exposed to short-term swings in its respective market which can sometimes have a large effect. Over the long term these tend to cancel out, and a diversified portfolio with rebalancing can shield the investor in the short term.
  • Indexing only protects through failures in individual securities. It does not protect against systemic problems when all stocks decline at the same time. When markets are heavily correlated, diversifying across asset classes does not help either. (No safe haven problem.)
  • During withdrawal phase you may be required to withdraw principal during severe economic downturns, essentially being forced to sell at firesale prices.
  • As more people jump aboard the indexing strategy it creates “technical” pressure on index funds to buy more components of the index. Forced buying causes prices to rise (micro economics 101) in the short term despite no change in the supply or “intrinsic” value of the underlying securities.
  • If the market fairs poorly over a long period (Japan over the past 25 years, countries with revolutions etc.) then you could be subject to average losses. That’s why it’s important to diversify geographically and by security type.
  • opportunity cost of not choosing a different strategy (ex perm portfolio, DGI, GARP, Value investing, technical analysis, HISA, small business, active mutual funds, black jack card counting etc.)