What Are Index Funds For In Tough Markets? Plenty…

One of the misconceptions people have about passive investing is that it’s a “set it and forget” approach to the markets. What are index funds for, some people ask me, if you just buy them and hold them?

Plenty, I say. First and foremost, index funds greatly reduce your risk of emotional trading. If you own, for instance, a large position in Apple (AAPL), you might have been plenty happy when it was zooming upward during 2012. Many investors were.

Ever stop to think about why it was rising so quickly? That’s right, it was largely because of those same investors. Our natural tendency is to buy a hot stock while it’s hot. When it returns, inevitably, to a realistic price, we sell out.

That’s buying high and selling low, the very opposite of what you should do as an investor.

An index fund investor would have had some exposure to Apple, just by owning the index. Crucially, owning all 500 stocks in the S&P 500 means you are less likely to focus on a single ticker with such obsession. Diversification buys you sanity.

Another advantage of indexing is that you neatly avoid market-timing traps. Too often, retirement investors get nervous about their savings (who wouldn’t?) and begin to believe that they can profitably trade the markets.

Nothing could be further from the truth. It might feel good for a few weeks to go to cash, but when do you by back in? Right before a double dip? Would you really recognize the eventual market bottom?

Market timing is incredibly hard to do. Professionals mess up their timed trades with regularity. The difference between you and a money manager is that if the manager blows a portfolio, he’s basically still in business.

If you blow your retirement funds with a single bad call, well, you’re out of business. All the years spent building up your nest egg are now wasted. I don’t mean to exaggerate, but this happens to ordinary people all the time.

Owning an index does mean that you are exposed to the markets, but that’s why you should own indexes in the form of a portfolio. By owning entire indexes across a variety of asset classes, you get the exposure you need in the right measure for the risk.

What are index funds for?

A young investor might be heavily into stocks, not just the Dow but small caps, foreign stocks and emerging markets as well. His or her bond portfolio would be small, and there would be a smattering of real estate and commodities on the side.

An older investor with more to lose would own close to the reverse. The bond portion would be greatly diversified, of course, to include income from dividend-paying stocks, emerging market bonds, corporate bonds and high-yield debt.

Both would rebalance — selling gainers to buy assets that have fallen out of favor — in order to capture gains from a moving market along the way. Index funds simply make this strategy cheaper to purse and, thus, a more effective way to build a retirement.