The stock market presents individuals and institutions with one of the easiest ways to invest and grow their wealth. However, due to the dynamic nature of stock prices and at times the costly investment required to buy blue-chip stocks, retail investors often find it difficult to diversify their portfolios well to mitigate market risk.
Statistically, index funds have proven to outperform most professionally managed mutual funds, which is why some of the top investment gurus like Warren Buffett and Charles Schwab recommend them.
Warren Buffett was once quoted saying “a very low-cost index fund is going to beat a majority of the amateur-managed money or professionally-managed money.” On the other hand, Schwab says that a young investor, who is just getting started and with limited capital, will find investing in index funds to one of the simplest ways to diversify their invested capital.
Therefore, from these few highlights, it is clear to see some of the top benefits that come with investing in index funds.
A quick rundown of the benefits of investing in index funds
Low expense ration
The average expense ratio for investing in index funds stands at about 0.50% (covering 0.30% stated expense ratio and 0.20% transaction cost). On the other hand, traditional mutual funds have an actual expense ratio of about 3.2% (covering, the stated expense ratio of about 1.3%, the transaction cost of about 1.4%, and sales charges of about 0.50%.
Access to a well-diversified basket of stocks
Another reason why investors choose to invest in index funds is because of the opportunity they get to invest in hundreds or thousands of stocks with low capital. Buying the minimum number of stocks required for every S&P 500 Index member company would cost more than it would if you invested in the S&P 500 Index.
Passive way of investing
Index funds also provide novice investors with a passive way of investing in the stock market. This means that investors do not have to deal with the confusion that plagues the market during times of uncertainty.
But despite these and several other advantages of investing in index funds, there are drawbacks that tend to put some investors off.
Drawbacks of investing in index funds
No downside protection
One of the biggest drawbacks that most investment experts tend to point out is the risk of exposure in the event of an economic collapse that leads to a stock market crash. Under such circumstances, most stock indexes would register massive losses. Since most index investors only buy long (they don’t short the indexes they invest in), this could result in massive portfolio losses.
To overcome such a challenge, investors can invest in more than one index with varied characteristics. For instance, they can invest in an index that tracks bonds, another that tracks gold prices and perhaps the S&P 500 Index.
Investors have no control over holdings
Since you invest in a pool of stocks that are defined by certain characteristics, at any one time if a member company loses some of the required characteristics, for instance, market capitalization, it drops out of the list. In a similar way, new companies can be added if they meet the set credentials to be included in the index fund.
The best way to overcome this challenge is to always keep an eye on the changes to the index funds. A news release apprises investors on all the companies that are new to the index and those that drop out. In this case, they can make a decision on whether to continue investing in a given index fund or switch to another. In addition, if a few companies drop out or join the index, this is unlikely to make any significant impact given the number of companies the index covers.
Limitation for investing strategies
Others have pointed out the limited ability to exercise various investing strategies while at the same time losing the ability to react to market mispricing. However, if you believe in your own ability, you can easily run a parallel portfolio alongside your investment in index funds to capitalize on undervalued stocks and practice various trading strategies like momentum investing, investing in spin-offs and capitalizing on mergers and acquisitions.
In summary, investing in index funds can be a revelation to several retail investors that consistently lose money in the market due to a lack of expertise. However, as clearly pointed out, there are a few drawbacks that they may have to come to terms with, in their journey as passive investors.
DISCLAIMER: This article expresses my own ideas and opinions. Any information I have shared are from sources that I believe to be reliable and accurate. I did not receive any financial compensation for writing this post, nor do I own any shares in any company I’ve mentioned. I encourage any reader to do their own diligent research first before making any investment decisions.
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