The stock market doesn’t look so attractive right now. Not surprisingly, activity in certain online investment forums has increased. The “hot new” strategy moving forward is, we are told, to “just buy an index and hold it”. This advice is coming from both independent investors as well as some financial advisers.
For quite some time now, buying an index fund or trying to “mirror the market” has been fashionable. It does seem to work, but why? And, is it a viable long-term strategy for most people?
Index investing is an investment strategy that tells you to buy stocks (or mutual funds) that mirror the performance of the stock market as a whole. It’s called a “passive strategy”, and the folks that buy into it have done so with great enthusiasm.
In fact, if you visit some of the investment forums on the internet, especially those that worship John Bogle, you may be excommunicated for mentioning anything other than index investing. It’s easy, and, let’s face it, the historical returns of the S&P 500, Nasdaq, or the Dow are quite impressive. If you track small cap stocks, it’s even more impressive.
The biggest problem is that indexing works only when a minority of investors are doing it. If, eventually, a majority of investors use indexing as their primary method of investing, it could destabilize the markets. Why? Because strong proponents of indexing either refuse to acknowledge or are ignorant of the fact that there is someone (in fact a lot of some ones’) making those index returns possible.
Without active investors, there is no one setting the price of stocks in the index.
In other words, there are many traders and investors that are buying and selling stocks in an attempt to make money – this activity is what makes the markets efficient. Without them, index funds and index investing, wouldn’t work.
Additionally, as individuals increasingly flock to this method of investing, transaction costs may rise to deter new money from unbalancing the efficiency of the market dragging down performance results.
Does that mean that you shouldn’t adopt index investing as your sole method of investing? No, of course not. Just realize that even when the markets recover, and I expect that they will eventually, that indexing is not the be-all-end-all strategy. If you do adopt it, keep in mind that the reason it works is because there are a majority of investors out there that are better than you at investing who are making the markets efficient enough for indexing to work.
If enough investors flood the market with a passive strategy in mind (I highly doubt this will happen, but I’ve been wrong before), you’ll have to learn how to actively invest if you want to make serious money from equities.
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This entry was posted on September 4th, 2012 by David. Edits may have been made to keep this entry current. · No Comments · Investing