For most people, in most situations, index funds are the preferred investment vehicle. But there are also some people – or certain circumstances – where index funds are not the right investment choice. As the saying goes, never say never, never say always. And so it is with index funds.
Here are five reasons why index funds might not be the right investment choice for you – or at least in certain situations.
When You’re Good at Choosing Your Own Investments
The whole purpose of index funds, and mutual funds and exchange traded funds in general, is to provide a diversified investment portfolio for people who are not very familiar with investing. But there are some people are, and if you’re one of them, index funds may not be the right investment choice for you.
If you’ve got the time, the patience, the resources, like Ascent Private Wealth, and the interest, you might even be able to perform as well or even better with your investments than index funds do. This is certainly not typical – the vast majority of investors, and even investment managers, usually under-perform the market.
But if you’re one of the exceptions, or if you just like the thrill of discovering and riding with your own stock picks, you probably don’t need or want index funds. Heck, Warren Buffett never used index funds!
When You Want NO Risk in Your Investments Whatsoever
After a five year run up in stock prices, many investors may have forgotten the fact that index funds do involve risk. After all, if the stock index that your index fund is tied to should fall significantly, you will sustain losses. An index fund will only perform as well as the index that underlies it. And if it falls, it will take your investment down with it.
Some investors are completely risk adverse. They want guaranteed investments, not those that can fall as well is rise. If this describes you, then index funds will not work for you – for that matter, no type of equity investment will work for you.
But that’s why there are fixed income investments, such as certificates of deposit, money market funds, and treasury bills. You’ll never get rich on them, but you’ll never lose money on them either (as long as you ignore the long-term effects of inflation).
If the prospect of watching your money decline in value will spook you and keep you awake at night, then index funds will not be the right choice for you.
When Interest Rates Are Heading Higher
The correlation isn’t exact, but generally speaking, when interest rates are rising, stocks are falling. This is especially true if rising interest rates are a long-term trend. That could be the case when inflation is rising, and interest rates need to increase in order to keep pace.
Rising interest rates can depress stock prices, because interest-bearing investments compete with stocks for investor’s capital. And when interest rates rise, investors tend to pull out of stocks and move into interest-bearing securities.
In that scenario, index funds will fall with the rest of the stock market. If it turns out to be a long-term trend, you could end up losing money on your index funds for several years. For that reason, if you have a strong sense that interest rates are headed higher, you might want to move out of index funds and into money market funds, since the interest rates they pay will increase along with rising rates.
When Stocks Are Moving Sideways
If the stock market is generally moving sideways, your index funds will do the same. Markets can stay in a holding pattern for two or three years, and as long as they do the returns on your index fund will be flat.
In range bound markets, it’s often preferable to switch out of index funds and into sector funds that are invested in industries that are continuing to do well. Even in a flat market, some sectors are rising while others are falling. The idea is to get into the rising sectors. That will enable you to increase your investment returns in an otherwise range bound market.
When the Market Looks Poised for a Fall
Since index funds are tied to the overall market, if the market looks ready for a big fall, your index funds will ride the elevator down.
Index funds are a perfect way to play a rising market. You buy into the index fund, then let the market carry it up. If it is a multi-year bull market, such as the one that we’re in right now, index funds can seem like money in the bank.
But rest assured that they are not.
If the market seems overpriced, it’s best to get out of index funds for a while. It’s not possible to time the market perfectly, but if the market is looking overpriced, you might spare yourself the worst of a major correction by getting out as close to the top of the market as seems reasonable.
And when the market completes its blowout cycle, you can get back in – using index funds.
What are your thoughts about index funds – all weather investments, or just fair weather investments?
James Hendrickson is an internet entrepreneur, blogging junky, hunter and personal finance geek. When he’s not lurking in coffee shops in Portland, Oregon, you’ll find him in the Pacific Northwest’s great outdoors. James has a masters degree in Sociology from the University of Maryland at College Park and a Bachelors degree on Sociology from Earlham College. He loves individual stocks, bonds and precious metals.