Index Investing – Is It A Good Investment Strategy? PillarWM
Investing in exchange-traded funds and index mutual funds garners plenty of positive press, and why shouldn’t it?
At their best, index investing is a low-cost method for investors to access and track popular bond and stock market indexes. In several cases, index funds can perform better than the majority of actively managed mutual funds. Nevertheless, investing in an index isn’t as simple and straightforward as it sounds. A financial advisor can guide you all about the intricacies involved in index investing or indexing. But before you hire a financial advisor, make sure to read The Ultimate Guide to Choosing the Best Financial Advisor.
At Pillar Wealth Management, our team of financial advisors offers investment-related advice to high net worth and ultra-high net worth individuals and families who have liquid assets between $5 million to $500 million. Our investment services include asset allocation analysis, research and due diligence, portfolio design, tax-loss harvesting, and monitoring and rebalancing portfolios. To get more information about the investing service we offer, click here to book a free consultation with one of our financial advisors.
What is an Index?
A stock market index is developed to carefully monitor the performance of any specific aspect of the market, whether it’s the rate of inflation or the 500 biggest U.S. firms. There are various tools that investors, economists, and other financial experts can use to track market exposure and performance in various methods.
An index is very similar to a ruler – it’s a tool to measure the price movement or performance of almost anything. From a financial aspect, an index refers to a group of investments, usually bonds or stocks that are included as investment vehicles, that represent the markets. Groups of investments, known as indexes, are developed to track things such as consumer prices for commonly used services and goods, publicly traded stocks, and bonds. In 2020, more than 3 million indexes were created to monitor almost every specific category of the market.
Some common stock index funds include:
• S&P 500:Tracks the stock performance of 500 of the biggest companies across different industries in the United States.
• Dow Jones Industrial Average: Tracks the performance of 30 big, publicly owned companies trading on the NASDAQ and New York Stock Exchange in the United States.
• Consumer Price Index: Uses the changes in prices over time that consumers pay for a basket of goods and services. This is the most commonly used index to track inflation.
• Nasdaq Composite: Tracks the performance of 3,000 stocks listed on the Nasdaq exchange
• Wilshire 5000 Total Market Index: It measures all Unites States equity securities with readily available price data.
• Bloomberg Barclays U.S. Aggregate Bond Index: Tracks the performance of Government agency bonds, corporate bonds, mortgage-backed bonds, treasure securities, and a small percentage of foreign bonds traded in the United States.
• Russell 2000: A small-cap stock market index of the smallest 2,000 stocks
• MSCI EAFE (Europe, Asia, Far East): Tracks the performance of stocks traded in developed nations outside of Canada and the United States.
• Vanguard 500 Index Fund (VFIAX): Tracks the performance of 500 of the largest companies in the United States.
• S. Global Jets Index: Tracks the performance of the global airline industry as a sector index.
Before we move ahead, we strongly recommend you read The Art of Protecting Ultra-High Net Worth Portfolios and Estates: Strategies for Families worth $25 Million to $500 Million. Reading this book will help you learn why your investments’ performance in the short term compared to the S&P 500 or DOW does not explain how well you are moving toward achieving your overall financial goals.
How Does Index Investing Work?
Now that you have a fair idea of what indexes are let’s take a look at how investing in an index work.
Index investing a passive investment approach that aims to create returns similar to a broad market index. Investors follow a buy-and-hold strategy to mimic the performance of a particular index – usually a fixed income or equity index – by buying the constituent securities of the index or investing in an exchange-traded fund (ETF) or index mutual fund that itself copies the index by holding all the index’s securities. Thus, when the index as a whole performs well, the value of the fund increases along with it, which increases the balance of the investor’s portfolio. To learn the difference between active and passive investment approaches, read our guide, ImprovingPortfolio Performance.
Note that you have to invest in an index fund, either through an ETF or an index mutual fund. This is because you cannot directly invest in an index, as it’s entirely a mathematical construct.
Investing in an index is a successful method to receive consistent returns and manage risks. One reason why this strategy is effective is that it steers clear of active investing. According to modern financial theory, it’s not possible to “beat the market” once taxes and trading costs are factored in. Click here and read our ultimate guide to get more details on why active investing approaches don’t help beat the indexes.
Are Indexes A Good Investment?
Index investing utilizes a passive investment approach which means index funds generally have lower expense ratios and management fees than actively managed funds. Index funds are also more tax-efficient than active funds as they make fewer trades.
However, the most essential thing about index investing is that it’s a successful technique to diversify against risks. Since an index comprises a broad basket of assets rather than a few investments, it reduces the unsystematic risk associated with a particular company or industry without lowering predicted returns.
Another benefit of index investing is that it’s completely transparent. Several index funds simply hold what’s in the index (which hardly ever changes), so you can review the funds holding anytime you wish. This transparency allows you to gauge better the risk of an index fund based on these holdings. For example, tracking a bond index fund may be less risky than tracking the unpredictable oil and gas sector.
Nevertheless, the question still remains, is an index a good investment? To answer this question, let’s take a deeper look at investing in index funds.
Indexes Are Not Always Created Equal
Opting to invest using ETFs and index funds is quite simple. However, deciding which ETFs and indexes to invest in is much more complicated.
This is because, just like any specific investment category, certain options will perform much better than others. Some might be riskier but offer a higher potential return. Some might be more stable and conservative and offer moderate levels of returns. Some are more volatile due to particular industries or companies they focus on. For instance, the DOW Jones Index Funds only constitute 30 companies, and investing money in this fund will limit you to a small percentage of U.S. companies.
An even more significant challenge occurs when an ETF or index undergoes some kind of internal upheaval. For instance, a group of companies or a key sector in a particular index fund can stop generating positive returns.
Moreover, index funds increase and decrease with the market. Hence, in case the market crashes, the index funds crash too. And in some instances, the equities constituting an index fund may have been aggregated based on dubious assumptions regarding historical performance. Additionally, all indexes are not equally safe. And some may have higher turnover and expense ratios, which can increase your cost.
All in all, selecting the ideal index funds for your situation calls for an extensive analysis. For high net worth and ultra-high net worth investors, this selection can lead to a difference of millions of dollars over the span of your investment. Click here to speak to one of our financial advisors and learn how you can choose the best-suited index fund based on your financial circumstances.
Index Funds Don’t Guarantee A Successful Investment.
Simply investing your wealth in an index fund doesn’t indicate that you’re on the path of attaining your financial planning such as student loans, real estate planning, credit cards’ management, or investment goals. Just like any other investment product, index funds are essential tools to preserve and increase wealth.
To gain the maximum benefit from investing in index funds, you need to have a comprehensive plan. For instance, index funds work quite well as part of an asset allocation strategy. Your fund managers or portfolio managers might develop a portfolio comprising index funds that are in line with your financial goals. In our guide for investors with $10 million and more, we discuss why intelligent investment is about asset allocation that is driven by your financial goals.
Index Investing Is Not the Same as Asset Allocation
If index investing was so easy, you could simply invest all your wealth in the same index fund. Given that it’s an index, it should be naturally diversified, correct?
Well, the issue is that diversification and asset allocation are two very different concepts. For instance, you will have a diversified portfolio if you invest all your wealth in the same index. However, it’s really not an ideal allocation. This is because if the market crashes, the index fund is going to crash with it, and you won’t have any way to protect yourself.
Hence, you require a better allocation that encompasses a collection of equity investments or stock funds along with cash and bonds. Click here to read our guide, where we elaborate on the five critical shifts you need to make for maximizing portfolio growth strategies.
The bottom line is that investing in ETFs and index funds is an excellent and cost-effective strategy to include in your investment portfolio. But like all other investment strategies, investing in index funds requires you to have a clear idea of what you’re investing in. Keep in mind that not all index products are created equal, and investing in index funds isn’t the same as asset allocation.
Can You Lose Money in An Index Fund?
All investments come with a certain degree of risk, and index funds are no exception. Mainstream index funds are generally regarded to be a safe and conservative method of investing equities. The primary reason for this is that index funds are largely diversified, spreading risk across several different securities.
Think of 100 random investment companies. The chances that a single investment company out of the 100 will go bankrupt might be significantly high. However, the chances that all of the 100 companies will go bankrupt is essentially zero. Therefore, an investment in an index fund has an incredibly low probability of resulting in anything near to a 100 percent loss.
Moreover, index investing also helps lower the management risk as they minimize your or your financial advisor’s responsibility in managing the funds and take a look at the lender reviews before filing the loan. As a high net worth or ultra-high net worth investor, you can simply purchase and hold these funds for several years or even decades.
Index funds are typically not as volatile as individual stocks due to their diversification. Nevertheless, you do need to remember that if the underlying index is volatile, then the index fund will also be volatile, given that it correctly tracks the index’s performance. For more detailed information regarding index investing, click here to schedule a free meeting with one of our team members.
The Bottom Line
Wealth planning that ensures your long-term financial security goes beyond choosing to invest in index funds. In fact, index investing is just one element of financial planning.
To know more about index investing and determine if it’s right for you, you can take a look at the comparison service website or you can get in touch with our team at Pillar Wealth Management. We offer exclusive investment-related services to those who own significant wealth. Our team has a collective experience of more than sixty years in creating personalized investment strategies for numerous partners such as individuals and families with $5 million to $500 million in liquid investable assets.
Pillar Wealth Management is an investment advisor that will stay with you for the rest of your life to ensure that you attain the financial serenity you deserve. So, what are you waiting for? Click here to set up a free meeting with our team!
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