Index funds can be a great investment strategy for beginners. It allows for quick diversification, passive investment, and low fees. But index fund investing is not for everyone. Here are some disadvantages of index fund investing:
Little Control Over Performance
Index funds track an index, and as such they are susceptible to the movements of the market. As an index fund investor, you don’t have any ability to control these movements.
Once the index fund is purchased, you are at the mercy of the market. There is no ability to rebalance holdings to affect the portfolio performance.
That said, index fund investing can be done alongside purchasing individual stocks to introduce some control over the performance.
Lack of Fulfillment for Investor
Index fund investing does not bring much excitement. Once you purchase the index fund(s) there is minimal maintenance necessary, and little to no active involvement.
On a regular basis, your portfolio should be re-allocated based on price movement, but there is no active trading. If you’re looking for entertainment or engagement out of investment, index fund investing may not be for you. You can explore more active strategies if you’re looking for more excitement.
Index fund investing may be boring, but it is an easy way to grow your money while directing time and energy elsewhere.
Not Suitable for Short-Term Investment
Index fund investing follows the market, which can be volatile in the short term. In the long-term, the S&P has returned ~10% annually, but the short-term swings can be drastic (think 2008).
Index fund investing is best suited for a buy-and-hold strategy, where you’re able to hold long enough to weather any market corrections. If you’re looking for short-term returns, a more active strategy would be better suited.
Average Return
Index funds are build to passively follow a given market index (e.g. S&P 500). This means that by investing in index funds, you’ll only ever do as wel as the market.
With index funds, there is no possibility of outperforming the market. That said, due to the passive nature of index funds, it allows you to get a strong return on your money, while directing your time and energy into other money-making endeavours.
Limited Control Over Holdings
When purchasing an index fund, you’re purchasing all the stocks in the index. There is no ability to increase holdings of stocks you like, and sell stocks you don’t.
If you’re looking for more control over what stocks you’re holding, value investing may be a strategy to explore.
Outsized Impact from Individual Stocks
Typically, index funds holdings are weighted by market capitalization. What this means is that bigger company’s stock price movement will impact the index fund price more than smaller ones.
For example, an S&P 500 index fund will hold the 500 largest public companies traded in the U.S. If held equally, each stock in the fund would make up 0.2% (100%/500). But because it’s weighted by market cap, the largest companies may each make up 5-6% of the fund.
The price movement of bigger companies will have a much larger impact than the smaller companies.
Vulnerable to Market Swings
Index funds match the performance of the underlying markets. As such, when the market swings, so do the index funds.
This means that the daily, monthly, or annual fluctuations will cascade into your portfolio. As such, your value can swing heavily. This creates challenge if you’re considering withdrawing, as the market may be down when you need the money.
As such, index fund investing is well-suited for long-term outlooks rather than short-term.
Limited Downside Protection
Because index funds are a collection of stocks, when the stocks go down, the index fund goes down.
Unlike an active management strategy where fund managers can use hedging or hold cash to provide downside protection, index funds will fall with the underlying stocks. As such, if you’re investing in index funds, it’s important to have a long-term outlook to ensure you can recover from market dips.
Index funds can also be owned alongside other assets like bonds that protect downside.
Limited Exposure to Different Strategies
With index funds, there is only one strategy – buy and hold.
Contrast that to purchasing stocks where there are a number of strategies based on how long you hold the security. Stocks can be traded with day trading, swing trading, options, etc. just to name a few. But with index funds there’s one strategy.
Index funds are great if you want passive investment, but will not provide the same engagement as other strategies.
Despite having disadvantages, index funds can be a great long-term way to build wealth and passive income. What some may see as a disadvantage (e.g. low excitement), you may see as a benefit (low maintenance). Index fund investing is a great strategy, but if you’re looking for more engagement, or the possibility of increase returns, it may not be for you.
Read on to learn more about building wealth.