Guest Author - Tony Daltorio
What exactly is an index fund? An index fund is a mutual fund which is designed to mirror the performance of a stock index such as the Standard & Poor's 500 index. To do that the fund purchases all of the securities included in the index and adds or sells investments only when the securities in the index are changed. There are many different indexes in existence but for our purposes here we will discuss index funds which are based on the major indexes such as the S&P 500.
Do index funds such as one based on the S&P 500 index make sense for investors and should they be a core part of everyone's long-term portfolio? The financial media tells the investing public that the answer is yes. This is just another one of the myths that Wall Street likes to have investors believe. But the answer to the question is a resounding NO!
Index funds are not a good investment choice. Index funds based on major stock market benchmarks such as the S&P 500 are only a good investment in extremely strong bull markets such as the 1990s. They only work in a market environment where a rising tide lifts all boats. These funds only work in this type of environment because they have too many stocks in the index;they are too diversified. An investor,depending on the amount of funds they have,should have from 5 to 50 stocks in which they are invested,not 500. More on that in a future article.
Another problem with an index fund based on the S&P 500 is that the index is weighted by market cap. In plain English,it means that larger companies such as GE or Microsoft make up a larger part of the index than companies down at position 499 and 500. A consequence of this is that these index funds own more of a stock when it is higher in price than when it is lower. I thought the old Wall Street adage was to buy low and sell high. These funds turn that thinking on its head.
These types of funds just weigh down a person's portfolio when the stock market is just flatlining or actually declining. Recent history offers a great example of this. Many people piled into S&P 500 index funds during the 1990s great stock bull market as they saw the index climb nicely year after year. These people thought - hey,investing is easy;all I need to do is buy an index fund and then I'll be able to retire rich a few years down the road.
Well,things have not worked out well for those people who bought S&P 500 index funds. In the past 9+ years,the S&P 500 index is actually down a fraction of a percent! And once you include the management fees on these index funds,people have actually lost a few percent on their money. Unfortunately,many of these people are still holding these funds and not investing the money in other more lucrative areas of the investing world. The message here is that index mutual funds should be avoided at all cost.
