ST. LOUIS, Mo. _Matt Allgeyer, Financial Advisor at Wamhoff Financial Planning & Accounting Services, discusses the importance of index funds.
1. Lack of Downside Protection
• Investors will reap the benefits in a bull market (such as the one we`re now experiencing), but will also be susceptible to a declining stock market or market correction.
• If the S&P Index is down 10% in a given year, an investor utilizing an S&P 500 mutual fund will experience that decline with no protection from that downside.
2. Little Ability to Outperform an Index
• Since index funds are mimicking an index, there is little ability to generate return above that of the index.
• Those using only index funds will experience average results.
3. Lack of Flexibility
• Because index fund managers must remain in lockstep with an index, there is no flexibility to capitalize on opportunities to purchase undervalued funds which could produce additional gain for the investor.
• Index funds must also purchase shares of a fund that has been recently added to the index in order to remain congruent with the index the fund is tracking. Due to the greater demand for the shares of the new entrant, the stock price tends to rise considerably, meaning the fund may be purchasing it at an elevated price.
4. Loss of Focus on Valuation
• Indexing focuses on owning every stock in an index regardless of value and price.
• For example, highly elevated valuations of internet stock were seen in the late 1990s, and money would have kept pouring into these stocks if an index strategy was used. This would have hurt the investors given the large selloff in internet stocks shortly after.
Both active and passive management can play a role in your portfolio, and investors must be informed on the potential risks and benefits of each. A financial advisor will help you develop a plan leveraging the most appropriate mix of investments for your goals and risk tolerance.