Index
Over the last fifty years, index investing has grown such that, as of the end of 2024, index products held more than $16 trillion in assets. Index investing has a number of advantages and disadvantages. Let’s review both.
Index Fund Advantages
The primary benefit of index investing is that it is simple and passive. Pick a fund, add money, set and forget. The second primary benefit is cost effectiveness. Since the fund manager is simply buying stocks representing an index, such as the S&P 500, Russell 2000, or Wilshire 5000, the management team can largely automate the process, thereby keeping costs quite low. A third benefit of index investing is automatic diversification.
Index Fund Disadvantages
The primary disadvantage of index investing, as far as we are concerned, is that you are buying “the market”, whatever that happens to be at a given time. Why does this matter? Experience tells us that just a handful of stocks drive the performance of any specific index. In the 60s, it was the Nifty Fifty. Currently, it’s the Magnificent Seven. You end up owning other companies that add no value to your financial life. Other disadvantages include lack of control over the timing of capital gains, as changes to the index lineup do occur. And significant downside swings when market leaders take days or months off.
Decision-Making Framework
How do you decide whether to use index funds or not? An employer-sponsored retirement plan can be an ideal place to opt for index funds, especially for those employees younger than 45. The entire process lends itself to the concept of indexing. For tax-deferred accounts such as IRAs, where taxable gain is not a consideration. These can also be ideal for index funds, again for those younger than 45. For smaller taxable account balances, such as balances less than $100,000 or $250,000. Another reason to use index funds? When goals other than “investing for the long-term” have not been identified. And finally, when you prefer to do your own investing, you want to minimize the time investment, and future goals aren’t clearly identified. Again, we have found this more common among those younger than 45.
When is it better to avoid index funds? First, when you prefer to avoid the volatility inherent in “buying the market”. When life goals are clear. As taxable invested assets move through six and into seven figures and the ability to control the timing and type of capital gains continues to become more important.
Actively Managed Funds or Individual Securities?
Actively managed funds can reduce volatility. They typically cost a bit more and do nothing for the ability to control timing of realized gains. So they can be an excellent choice for retirement plan participants who want to eschew index volatility.
Can you achieve meaningful diversification with individual securities? According to research by Benjamin Graham and David Dodd, writing in Security Analysis, Intelligent Investor, and elsewhere, diversification can be achieved with fewer than 40 individual stocks. Graham and Dodd are the pioneers of what is referred to as value investing, a philosophy to which we fully subscribe.
Our experience? A carefully built portfolio of no more than 40 dividend-paying stocks can a) lead to excellent long-term results, b) reduce volatility, c) give the investor complete control over the timing of realized gain, d) allow the investor to maximize the benefit of charitable giving of appreciated securities, e) allow the investor to experience a portion of total return in the form of cash dividends, and f) allow the investor much control over investing in companies which align with their philosophy and values. An index fund can do few to none of these things.
Timing
For those of you who prefer an S&P 500 Index fund, when do you buy? According to Macrotrends, the S&P 500 Price Earnings ratio, one of the metrics used to determine the richness of valuations, is just over 28. Over the last 90 years, it has been higher just three other times, in November 2001, May 2009, and November 2020. If I were buying index funds at the moment, I would do so only with a dollar-cost averaging (DCA) approach.
Summary
We all have options, which is one of the things that makes our world such a joy. Give thought to your preferences, your goals, and your future, and choose options which work for you. And I welcome your feedback and input on this and any other topic.
And until we see you again, wishing you only the best.