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Can Any Index Investing Strategies Guard Against Failure?

02/15/2019

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Many novice and first-time investors are interested in investing in an index mutual fund, but are perhaps concerned about some of the associated risks. In particular, some potential investors will be concerned that a given index will collapse, leading to a complete loss of investment.
The risk of an index collapsing entirely is extremely low, which will be addressed in detail below. That said, there are some index investing strategies that investors can utilize to further hedge against losses and protect their investment.
Read on for a full overview on index investing, as well as a number of index investing strategies that both novice and experienced investors can include in their respective approaches.

What is Index Investing?

Buying an index fund is the primary way of index investing, which basically involves purchasing a diverse basket of stocks, rather than significant shares of a given individual equity.

Index funds are constructed to match or track most of the individual components of a market index. The most commonly-copied index is the Standard & Poor’s Index 500 (S&P 500), which most investors believe best represents the current U.S. equities market.

While broad-market indices such as the S&P 500 are among the most popular choices for index investment, there are hundreds of indices an investor can buy into, each with respective benefits.

Alternatives such as the Columbia Dividend Income Fund (LBSAX) are among the best dividend indices that an investor can purchase. Constructing an index to include nothing but stocks with above-average dividends is just one way in which a fund manager can compile an index, and just one of the dozens of index fund options for an investor.

In most cases, an index mutual fund provides an expected collection of benefits, including exposure to a broad number of markets and sectors, relatively-low operational costs, and low portfolio turnover.

Index fund investment is a type of passive investing, which holds a number of advantages over equity trading and other forms of active investment.

The main way in which a passive investment strategy is superior to active investing is that passive investments such as index funds offer lower MERs (management expense ratios). This ultimately can mean more money in your pocket.

Why Partake in Index Investing?

The two primary reasons investors go with index funds rather than individual equities are probably the reduced fee schedule associated with indexing, as well as the relative degree of safety that an index fund offers compared to individual equity investment.

As with all forms of passive investing, index investing will work well for investors who are prepared to sit on their investment and mostly keep their hands off the wheel. Those with higher risk tolerance or those who want to vigilantly monitor the market will likely do better with a form of active investment such as individual equity trading.

But if an investor has the disposition to thrive with a form of passive investment – as well as the discipline to let an index rise and recede without taking action – then there are a number of specific benefits to index investing.

Benefits of Index Investing

Index funds have become a very popular form of investment for a number of reasons, as index investing seems to strike a sweet spot for a lot of investors in terms of reward versus risk.

To begin with, index funds are seemingly attractive investments when it comes to a well-balanced portfolio. Aside from being highly diversified and broadly exposed, these funds have low expense ratios and management fees. This makes an index fund inexpensive to own compared to most other types of equity investment.

This high diversification of index funds practically denotes that an investor can sample several different industries, market sectors, and stock classes without having to do much of due diligence on individual stocks. An index investor can try diverse markets such as healthcare, consumer goods, and real estate without overcommitting to a certain individual equity or overinvesting in a given sector.

If you’re new to investing, index funds could be a safer way to invest and get yourself exposed to different equities available. The same could be said if you’re looking to long-term investing or if you simply don’t want to spend too much time on portfolio management.

Can Indexes Fail?

This is likely the biggest concern novice and first-time investors have with index investing: the belief that an index can collapse entirely, leaving the investor with nothing to show for a given investment.

While the finance world may only have limited certainties, the chance that an index or the fund that tracks it leads to value loss is close to zero.

There are several factors that account for this. Virtually, all indexes and index funds are very highly diversified in terms of operations. As explained above, a good index will include no less than 40 or 50 stocks, with many broad-market indices including 500 or more secured equities.

Several index funds tend to resemble a large chunk or index of stocks such as the S&P 500, which happens when the stock’s identical weights are bought and sold as the index itself.

Due to the high diversification of an index fund’s holdings, it’s virtually unlikely for each holding’s value in the fund to fall to zero.

In addition, the overall U.S. stock market is highly likely to produce tangible value over a long period. Hence, the stocks’ total book value is highly to go up over the long term.

As a result, the value of any well-diversified index fund will not significantly decline over a period of time. Where investors run into trouble is when they sell or withdraw at the first sign of trouble.

A good index investor will need to be prepared for the occasional downturn, and be able to handle declines with composure.

Key Index Investing Strategies

If an investor opts to go with an index fund, there are a number of index investing strategies to recommend.

Don’t Panic at the First Downturn

This seems like common sense, but the reason passive investing works very well for some people and not so well for others is that some people are apt to sell at the first sign of a problem.

Index investing is proven to work over a long-enough timeline. History has shown that the U.S. stock market will always rally. But an investor needs to have the composure to hold the index fund if it ebbs a bit.

Stick to Broad-Market Indexes

A broad-market index such as the Vanguard 500 Investors Share index or the Wilshire 5000 Total Market index will include hundreds or even thousands of equities.

The likelihood that all the holdings from so many diverse market sectors – which again could include healthcare, real estate, energy, utilities, and more – will simultaneously collapse, or even recede, is extremely low.

In fact, broad-market indices are constructed to protect against this concept, much like a tightly-knit web. If a market sector such as healthcare happens to see a downturn, there’s still an excellent chance than an alternate sector such as technology or energy is thriving.

If you are a first-time investors and want to mitigate risk as much as possible, a broad-market index investment is probably the safest alternative to a low-risk/low-upside investment such as individual bonds.

Review an Index Carefully Prior to Purchase

Indices are bond fund products, and some will have better marketing than others. It’s crucial for potential investors to do a bit of diligence prior to purchase, and determine exactly, which equities are held in a given index.

While fund managers will attempt to match an index to a given market as closely as possible, there’s always the chance that a manager will be unable to purchase shares of certain stocks. Thus, it’s in an investor’s best interest to nail down the holdings in a given index before buying it.

Work with an Experienced Fund Manager (or Several)

While one experienced fund manager can be a great asset, smart investors have learned that using several manager across multiple index funds can have even greater benefit.

A great way to ward against overlap is the use of multiple fund managers. While this approach can incur additional fees, an investor is also protecting himself or herself against overinvestment in certain equities or sectors.

Winning with a certain equity or sector will inspire most managers to continuously go back to the well. If a manager does well in healthcare, for example, it will be simple human nature to go with what has worked in the past.

Using multiple managers gives an investor a fresh perspective on not only the index fund itself, but also on the market as a whole.

Experience and insight both have intrinsic value, and utilizing multiple managers is a great way to not only improve returns, but also to gain better overall perspective on the market

Better Index Investing Strategies for Optimal Returns

If you decide that index investing is right for you, putting some of the aforementioned index investing strategies into practice will likely help you maximize returns, while also helping you mitigate some of the potential risks.

Linden Thomas & Company

One of America’s Top Wealth Managers builds a better Index

At Linden Thomas, we believe most indexes focus on the wrong things like weighting the index based on the size of a company (market cap).

We agree with many long-term academic studies that continue to validate the importance of how quality earnings are directly connected to real equity performance…

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