Index Fund Investing: The Bad News

Wait, Index Fund Investing sounds perfect, easy and safe what could possible be bad. Just pick the specific index with the diversification, total return and standard deviation of return that you are comfortable with and hope the market goes up and the wealth to roll in.

OK, successful index investing may not be as easy as it sounds. Some the very features that make index investing great are also weaknesses.

Index funds offer a low cost way to invest and diversify across a larger group of stocks. However, by their very nature they are at the mercy of the direction of the stock market. Even if you diversified between the S&P 500 and the Russell 2000 you still had a portfolio of stocks subject to the whims of the overall direction of the stock market. Yes, they will help you mimic the return of the benchmark index but sometimes that is not such a good thing. In the 2000 – 2002 decline the steady S&P 500 index lost over 45 percent from top to bottom. Few investors can stomach that kind of decline. Oh, it may be easy for a 30 year old with 35 years to recover, but it's harder for the 62 year, near retiree, to watch and hold a portfolio that just cut in half. What often happens is bailout at or near the bottom. But these type of regular boom and bust cycles are all part and parcel with index fund investing. Some of this can be removed with Asset Allocation , but this also has a down side and can significantly diminish the portfolio return. A better way to relieve the danger is Mutual Fund Switching or even simple Market Timing . These both enhance Index Fund Investing returns and decrease the overall risk. They also help eliminate a large portion of the Index swings associated with the standard deviation of returns. Put simply, this means how big are the plus or minus returns each year verse the average. An example: Fund “A” and Fund “B” both have an average return of 20% per year. Fund “A” has returned 19% and 21% to give the 20% average. Fund “B” however, returned 80% and minus 40%. Both have the same average but fund “B” would be a little harder to live with, especially if the minus 40% came in the first year. So, just like most mutual fund investing Index fund investing work good in the up years and not so good in the down.

Index Fund Investing has its strengths and weaknesses. Overall the weakness can be easily handled by Dynamic Asset Allocation and it can be dramatically improved upon with Mutual Fund Timing. With a little investor involvement in can be a low cost, low risk investment strategy.