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How Not To Use An Index Fund

Rarely does a day go by without some endorsement for the wisdom of investing in index funds. The more this mantra is repeated, the more we see misapplication and frustration from investors attempting to follow this advice.

Understanding this, know that index funds can be an efficient tool, but they do not cure cancer. Although they are simple to understand conceptually, successfully building portfolios using index funds can be rather complex.

John was one recent case. He is a smart guy; a pharmacist by trade. His entire portfolio was in index funds, but his performance stunk.

After reviewing his statements, the problem was apparent. He had an index fund tracking healthcare, while another tracked the energy sector. A third followed fixed income markets, but used derivative contracts to double the performance impact.

He previously owned an index fund tracking the broad U.S. stock market. However, he sold it because it kept going down over a years’ time.

John had gone from being a believer to someone who threw up his hands in frustration.

Most investors fail to understand that index funds, when used properly, can offer low cost and efficient access to assets. However, it is not a “one-size-fits-all” decision or a simple one. It requires very similar discipline as if managing a portfolio with individual securities.

Major brokerages offer more than 60 different index funds. However, before ordering off the menu, answer some basic questions.

First, what is your time frame? If you need money to pay for a car next year it is ridiculous to invest in a stock market index fund. The short-term results will be highly random and potentially quite volatile.

Whether you own individual stocks or stocks in a fund, your time frame needs to be ten-plus years.

Index fund disciples often forget that when the stock market drops by 60%, that fund will follow the index down lock-step. During a strong bull market, like the last nine years, they forget that from 2000 to 2009 the S&P 500 index went nowhere.

Index investors do not insulate themselves from market volatility. They must embrace it.

Another key mistake is jumping in and out. A major key to successful investing is discipline—stick to the plan when things get rough!

This is well documented by the DALBAR studies showing the average investor underperforms the stock market indexes by more than 70% over long periods of time. Some of this is due to fees and manager performance. However, investors are harming themselves if constantly jumping in and out. If you want the true long-term performance of the market, you must stay consistently invested.

If you decide to own an index fund specializing in one area such as healthcare or energy, you better be one of the world’s leading authorities on valuing assets in that industry. Otherwise, you have no business chasing after sectors, as it is nothing but gambling.

This brings up another good point about investing in general. A fundamental understanding of how to value assets and markets is quite helpful. This is true whether buying a new car, a house or an index fund. You are paying out money—what are you getting in return?

Is it a good deal or not? How do you know?

Additionally, if interested in index funds, do you want exposure to stocks, fixed income, real estate or some other specialty asset class?

If you desire exposure to stocks, do you want domestic, foreign or emerging market assets? Do you want exposure to large, medium or small companies?

Once these questions are answered, investors must identify if they want an index weighted by market capitalization, an equal weighting to all securities, or by some valuation criteria?

A similar process is necessary for investing in fixed income indexes. Do you want domestic, foreign or emerging market assets? Do you want high quality or low quality? Do you want short, medium or long maturities?

Obviously, in answering these questions, an investor should understand that index funds can offer low cost and efficient access to specific markets.

However, tremendous care and consideration must still be applied to selecting the indexes you wish to track. You must then have the appropriate time frame, goals and emotional stability to see the plan through to fruition.

Dave Sather is a Certified Financial Plannerand owner of Sather Financial Group. His column, Money Matters, publishes every other week.