The Risks Of Passive Investing: Understanding Index Funds
I was recently asked if Index Funds (fill in any investment product you like) are a good investment. I used to reply, in standard “brokerage” (sic), that “Yes, Index Funds can be an excellent investment in a well-diversified portfolio of high quality, conservative stocks, and bonds.”
It’s just what they taught us in Broker School, a safe way to answer the question. But regrettably, an answer that doesn’t tell the whole story. I asked today, and I’d reply that Index Funds (or any other product) are not a good investment, at least not in the way you’re thinking of “investment.”
In the last 50 years, there has been a dramatic change in the way the Financial Services Industry operates. That it is an “Industry” indicates how far we’ve come in money management.
Today, we’re talking to the average investor, someone who has a few thousand to even a few million dollars to invest. If you are one of the fortunate few with more than a few million dollars to invest, we’ll address your issues in another column.
But perhaps you’ve been blessed to have what you consider a sizable amount of money you need to invest. Every day, you feel the pressure increase to do something, anything, with those funds. You know the opportunity cost of just letting those funds sit idle. My father had an expression for this, “the money is burning a hole in your pocket.”
It’s true. You have money, and you must put it to work. Others have done that and multiplied their wealth. Why not you?
You decide to call your local stock broker, financial planner, investment advisor, or, heaven forbid, accountant, or worst of all, attorney. They may invite you to lunch. After a beautiful meal, they explain that they have an excellent program, and everyone they put in it has done great; why not invest in Index Funds? Expenses are low, and returns up to now have been exemplary.
You thank them for the lunch and indicate you’ll get back to them.
In the back of your mind, you’re wondering what’s an Index Fund. The answer is all part of those changes in the financial services industry. At its core, an index fund is a passively managed fund that invests in a given benchmark called an index. The most popular is the Standard and Poor’s 500 — a collection of the 500 largest, most expensive stocks.
The operative word here is “passive.” Neither your friend who recommended the Index Fund nor the management of that fund decide when to buy or sell a stock or when you should invest or liquidate in the fund. It’s all passive.
To the degree that your friend has recommended that you invest in an Index Fund, most of the time, they are making that recommendation based on some passive investment model. The fund itself only invests in a manner to replicate its benchmark. In our example, the S&P 500 Index.
Everything that has occurred up to now is passive. The underlying assumption is that things will continue along just as they have. That the returns investors received a couple of years ago will continue. But will they?
It’s a critical point that must be considered to protect your wealth. You worked long and hard for the funds you’ve accumulated, and you’re now on the verge of handing that nest egg over to someone you assume will look after it. And there was a time, 50 years ago or so, when Investment Professionals took a personal interest in your portfolio’s success.
However, while that kind of professional oversight may still exist at the highest levels, for most of us, investing today is much more mechanical than that. We are all lumped into a group of investors with a similar profile, same age range, similar investment profile, and similar wealth. And once in that “group,” we are placed into a passively managed “fund,” like an index fund.
Here’s my bottom line: Index Funds or other passive investments can be an excellent way to invest as long as you understand that you are in charge. In this new investing world, you must be the “boss.” An Index Fund is just like an automobile; it will be a superb investment vehicle as long as you realize that you must drive it. You are the one at the steering wheel. It would be best to have a good idea of where you’re going in, how much risk you’ll take, and whether or not it’s time to stop the car and get out.
We are entering a rough spot along our investment road. The weeks and months ahead will differ significantly from where we’re leaving. You should underline the old saw: “Past performance is not a guarantee of future returns.”
Unfortunately, in today’s modern investment world, the only one looking out for you is…you.
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