Investing in Index Funds:

3 Major Drawbacks

Investing in index funds for the long term is the bad advice most often given out by conservative investing pundits and all sorts of personal investing publications and blogs (that is, when they're not giving out the equally bad advice of investing in actively managed mutual funds).

An index is merely a basket of stocks that are tracked and are supposed to be representative of either the broader market or of some aspect of it.

For example, the Dow (Dow Jones Industrial Average) tracks 30 "blue chip" large cap stocks across a variety of industries, the S&P 500 tracks a much larger sampling of 500 large caps, the NASDAQ 100 focuses on large, actively traded, and non-financial companies, the Wilshire 5000 attempts to be truly representative of the entire U.S. market, and the Russell 2000 focuses on the small cap universe.

There are a variety of other indexes that represent other aspects of the market, including those based on specific industries and sectors.

Investing in indexes has traditionally involved buying units of those mutual funds designed to mirror the performance of a specific index. Generally, index funds do a pretty good job of tracking the underlying index, but due to the fees charged by the mutual fund, however low these might be, investors can expect to lag the actual index by a small amount each year.

More recently, exchange traded funds (ETFs) have begun supplanting mutual funds. ETFs trade just like regular stocks and can be bought and sold in real time in a personal brokerage account.

The Index Investing Dogma

So what's the rationale for investing in index funds? There are two basic premises at work:

Diversification is Crucial - Investing in a broad based index fund will protect you, so the theory goes, from catastrophic and permanent losses due to the bankruptcy or permanent impairment of any single company. If you own pieces of 500 companies and one of those goes broke, your diversified portfolio will fairly easily absorb the loss. But if you only own five stocks and one of those goes under, you're definitely going to feel it.
The Average Investor is an Idiot - Please note that this is their premise, not mine. The premise is that the average investor is too ignorant, too dumb, or too lazy to intelligently evaluate an investment in a publicly traded business. The average investor, therefore, is better off dumping all his or her long term investment resources into an index fund and just forgetting about it.

Everyone is NOT Average

There's a third assumption made by the investing in index funds crowd that's downright sinister. It's an implied assumption, but it's nevertheless very real.

And that sinister assumption is this: everyone is an average investor. Including you. Therefore, considering premise #2 above, you are an idiot.

I do understand the rationale for encouraging those who have money to invest but have zero interest in self directed investing to go the investing in index funds route. Over the course of several decades, that approach should both preserve the passive investor's capital as well as provide returns that exceed CDs and money market returns.

And I do not in any way mean to imply that those who have no interest in Wall Street are idiots. I'm merely pointing out that the advice givers are implying that you and I are idiots.

The Major Drawbacks to Investing in Index Funds

So how well does investing in index funds hold up under any kind of scrutiny?

Hint: Not very well at all.

Here are what I consider to be 3 major drawbacks to investing in index funds:

Poor Returns - Buy and hold investing collects its share of derision in investing circles. But that's largely due to the performance of index investing.
There's this misconception about the stock market, that the long term returns average something like 10-12% a year. Unfortunately, (A) That's not actually true, (B) Average return doesn't mean consistent return, and (C) The most important factor in passive investing is whether the market is experiencing a secular bull market or a secular bear market.
Secular bulls and bears are long term market trends lasting years, generally between one and two decades. I've referenced elsewhere this table that profoundly illustrates the phenomenon, going all the way back to 1802. The average returns of the overall market during secular bull markets is 13.2% while the average return in secular bear markets is just 0.3% - much less than inflation.
Here's an example that hits closer to home. The S&P 500 opened in January of 2000 at 1469.25. Eight years later, it ended 2008 at the 903.25 level. That means an optimistic index fund investor who bought in January of 2000 would still be down 38.5% eight years later. Kind of hard to retire on that, I imagine.
Investing in Mediocrity - The primary reason why the returns are so poor with indexes is that, by their very nature, they represent investments in mediocrity.
Diversification via index is a blend of idolatry, superstition, and a basic lack of common sense. It's a notion that says instead of buying five or ten of the best run, consistently profitable, and financially strong companies that you can identify, you should instead buy a huge hodgepodge collection of stocks that, for the most part, you really know nothing about.
That's some logic: the only way to be sure that you get the best stocks is to buy all stocks - the great, the OK, the mediocre, and the soon to be bankrupt.
Disengagement from Your Investments - This drawback is usually overlooked, but in some ways, it's perhaps the most damning indictment of all.
The word "invest" originally meant "to clothe in official robes." That implies a significant level of both intimacy and respect. It doesn't imply carelessness or indifference.
Investing in index funds is the expectation of (or at least the hope for) money but without the interest in understanding how it's made. If you desire money, but want no part of its reality, just how successful do you really think you're going to be?
Excellent returns on your investments require that you invest in excellence. And that you embody excellence in the process.
Here is what I believe: Double digit returns through zero effort, understanding, or curiosity is no one's birth right.
True investing is a deeply personal and deeply satisfying endeavor. As any successful investor will testify, the rewards are more than merely material. They encompass the entire package: the intellect, the emotions, and the visceral.
As investors, we strive to compound at 10% or 15% or 20% a year or more not because we're greedy or because we want to be rich above all else. We do it because we want to prove to ourselves that we can. We do it because the human spirit recoils at being told that it is incapable and inadequate. It recoils at being told that is average.