“Whether you take a risk depends not just on the probability that you are right but also on the consequences if you are wrong.” – Peter Bernstein
Common sense reader mailbag: You write a lot about investing in index funds. Are these truly the best investment option or are there alternatives that I should be looking for?
Index funds are a great investment option for most investors. You gain broad diversification at a low cost without having to assess the wide range of other factors that are involved in actively managed strategies.
Index funds offer you a simple choice with a very high probability of success over the alternatives. For these reasons and many others I have cover in the past (here, here and here), the majority of investors should be able to achieve their goals by keeping things simple and investing with index funds.
But I don’t pretend to have the market completely cornered in the best investment ideas department. If you have a long-term process that you plan on using to reach your goals but you don’t use index funds, who am I to tell you that you’re doing it wrong? Sticking with your plan far is more important than anything else you do.
Asset allocation, dollar-cost averaging into the market, global diversification, keeping costs and transactions low, systematically rebalancing, thinking long-term, ignoring the short-term noise, sticking with your plan through good markets and bad – these are the important components you need in an investment option to have success.
Index funds just happen to be the most effective option for putting all of these components together through an investment plan in an easy to understand way.
Index funds let you participate in the long-term positive returns of the market (less a minimal fee) but you also get to participate in the market losses that occur from time to time. That’s part of the deal. As we have all experienced, markets can go down quite a bit in a very short period of time.
Getting greedy during rising markets or panicking during falling markets is a sure way to lose money. Allowing overconfidence and fear to take over at market extremes and completely giving up on your investment plan detracts value no matter the investment option you choose. That’s why behavior is such an important component of any successful investment plan.
Sometimes you have to invest during falling markets even though it would feel much safer waiting for an all-clear signal (that will never come).
Your long-term process matters much more than the vehicles you use to implement your plan.
It doesn’t matter if you’re invested in index funds or micro-cap IPOs if you can’t stick with your rules-based approach through the ups and downs. You won’t succeed at building wealth by switching strategies every time you feel nervous or excited.
DO YOU HAVE THE TIME?
Most every day investors don’t have the knowledge, experience, or time to put in the effort to use other investment strategies.
If you plan on going another route, make sure you can put in the time, come up with a rules-based approach and keep your costs low while thinking long-term.
Even if you don’t invest with index funds, you can use them as a way to benchmark your performance. At least once a year, compare your investment results to broadly diversified index funds. This gives you the chance to see if all of the extra effort you are putting in to implement your non-index fund investment plan is worth it.
Use an index fund portfolio as the baseline scenario against which all other investment options are considered. This will also give you a fallback if you decide you no longer have the desire to implement your current strategy.
For those who don’t have the time or inclination to develop their own strategy, but would still like to make some investments in individual stocks or other securities, the best option I have found over the years is to set aside 5-10% of your portfolio to make some tactical investments with some “fun money.”
That way you have 90-95% of your portfolio locked up in a sensible, low cost strategy with the option to have some fun with a smaller portion of your funds. It’s exciting to follow individual companies and can be a great learning exercise as well. There are just greater risks involved if you don’t know what you’re doing.
By setting aside a small pocket of your portfolio for these kinds of investments, you decrease the risk of having one or two bad decisions completely ruin your portfolio. At the same time, you can take some chances and make some higher risk investments.
So, yes, I do think for the majority of investors, index funds are your best investment option. That doesn’t mean they are the only option.
The best investment option is the one that helps you control your behavior while using a sound rules-based process.