Thursday, August 21, 2014

Should You Switch to an Index Fund this Year?

Out today, multiple articles on the recent explosion of the popular index fund investing strategy.  See for example, Vanguard Total and Buffett's Advice.  As I have shared in previous posts, index fund investing is the strategy where you place your money in a fund (Mutual or Exchange Traded) that tracks an index, like the S & P 500.  The latest research supports this investing strategy over, say, an active one where you place your cash with a money manager.  Warren Buffett, the world's greatest investor, has for years espoused this strategy for long term positive investing results.  He has cited the better statistical results of index investing over most actively managed funds over the course of time as the major reason to choose index over active.  He's also made it known that the fees you pay, a premium over a low-cost index fund (such as Vanguard's Total Stock Market Fund, ticker: VTSMX) are not worth the money and eat up returns.  Buffett has a lot of sway.  There's a celebratory party going on at Vanguard and Buffett's partly responsible for it.  Thousands of investors have poured in billions of fresh dollars into an index fund this year, in particular, VTSMX, making it today the largest mutual fund in the world!  Like the ice-bucket challenge, has this trend reached a level of idiocy?  Are people rushing into an index fund because others are doing it too, i.e., following the herd?

The answer to both of my previous questions are a definitive, Yes and Yes.  It is beginning to seem as if people believe index fund investing is risk-free.  New money has been pouring into the stock market for quite some time.  With the bull running on five and half years, people are starting to feel comfortable investing in equities just now!  They're either coming back in or just starting out.  The timing could not be any worse.  Or conversely, if I am wrong (and there is more left of this rally), the timing could not be any better.  But you've been told not to time the market.  But you've been told market timing doesn't matter as long as your investing time frame is long, in the multiple decades.  But, but, but......moooo!


Would timing have mattered in 2005, when everyone told you to buy a house, and that homes could do nothing but continue to rise in value?  Look, here's the bottom line: timing does matter, however, you can't be indecisive or on the fence forever.

Did you put your money into (or switch from an active fund) an index fund this year?
So far you have not been hurt by the decision.  Yet again today, the S & P is up.  In case you don't know, let me share with you why you could be in trouble and let you know what you will need to do to "ride out" your troubles.

A portfolio of passive mutual funds that track a given index, will track the performance of the index almost to the tee.  If the index goes up, so does the fund that tracks it.  If the index goes down, such as in the case of a market correction, so does the index fund your money is in.  Here's a hypothetical scenario.  I'm a "Millenial" professional that has placed $10,000 of my hard earned money in Vanguard's Total Stock Market Index Fund.  This was money I had saved for two years and had until recently kept in a savings account earning virtually nothing for fear of the market.  Being a novice, I have no idea of market timing and I believe that my 30 years left of work as a new teacher will save me from any losses.  So far, I've made a little over $500 (in line with the performance of the S & P this year) and am pleased with my investment.  There's a  market correction of 35% sometime this year and the fund correspondingly drops.  I'm in the red over $1,000.  I don't have any cash on hand and won't for some time.  I panic thinking that the market will continue to drop, and feeling defeated, "the pain," as it is commonly known, I decide to sell, incurring a substantial loss.  DO NOT SELL!  Unless you have to.  There could be an emergency in your life requiring you tap into all of your money sources, including the shares of your mutual fund.  There are no ways around a forced sell...because we never take money loans or use our credit cards!  Bite the bullet, claim your "realized" losses at the end of the year during tax season.

What should you do?  Investing in an index fund is not a one time decision, unless you start out with a whole lot of money and even then....What you should do is buy more shares of your low-cost index fund systematically, as the fund share price drops.  The smart investor has a reserve of cash to mobilize when the going gets tough in the market, to pick up additional shares of their favorite equities they hold in their portfolio.  This is called, buying the dips, and it's a great strategy for investors with time.  If you can't buy during the dips, for lack of cash, your only recourse is to Hold long term, and wait for the market to swing yet again.  This could be quick, historically average, or it can take a long time.

I have shared also in previous posts, why an actively managed fund has its perks and advantages.  Some professional money managers are great at their stock picking, and understand economics, timing, etc., better than you do.  They have a fiduciary responsibility to safeguard your money and dampen your losses.  There are cases of certain actively managed funds doing better in down markets, holding resilient stocks and fewer, more volatile ones.  Here is an article that actually supports actively managed funds.  It is a breath of fresh air in today's financial literary world.  Why you shouldn't put all your money in an index fund.

Leave the grazing for the cows!  Until next time.  Any Questions?  

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