Financial Idea's Blog

Why Shouldn’t I Just Buy An Index Fund?

Okay, on this one, I’ll start off by noting that, just like the idea of doing-it-yourself, it’s entirely possible that this could work, and in some specific time periods in the past it has worked. Of course, funds which follow the same index but are from different fund families behave a little differently, and within fund families there are funds which track dozens of different indexes. My English teacher would remind me that I should say “indices”, but I do what I do, and she does what she does.(That lesson did actually stick, I’m just having fun today.)

Let’s look at one of the most popular indexes, the S&P 500.

Lots of fund companies offer a version of this, which essentially is designed to take a weighted average of the top 500 performing stocks and roll that into one entity which many of us decide should be called “the market”. The market is actually a much bigger thing, but we’ll go with this common viewpoint for now.

Here’s what happens: the 500 stocks which make up the average are not randomly chosen. They are the best performers at the time, according to the parent firm which runs the index, Standard and Poor’s. Standard and Poor’s (or S&P), decides on a fairly frequent basis whether or not a given stock should be added to the index because of its great performance. The index, however, cannot become the S&P 501, which means simply that in order to add a stock, another one must be removed.

If a company merges with another company or goes out of business, that’s an easy situation. The index cannot become the S&P 499, either, so the next best performer gets added and the weighted average is recalculated.

Now, remember what I’ve said before about buying low and selling high, and, although it can be emotionally difficult, how it doesn’t take much of an intellectual stretch to see why that’s a good idea. Does this index work that way? Or not?

Remember, when there’s a vacancy, the next best performer is added. If a great performer just cannot be ignored, then the index’s worst performer, at the moment, can be removed in its favor. What does that mean? It means that the index is effectively selling low, by removing low performers, and buying high, by adding top performers. Read that again, selling low and buying high. If you own that index, or any other index, that’s what happening, and you don’t have any choice in the matter.

Last but not least, are you comfortable owning all 500 of those stocks? While many investors are okay with whatever they’re invested in as long as it makes money, many other investors have an explicit desire to stay away from certain things that don’t appeal to them. Let’s take the so-called “sin” stocks of alcohol and tobacco. The S&P 500 of April 1^st, 2010, contained Altria (MO, the former Philip Morris), and Phillip Morris International (PMI), formerly part of Altria but spun off to reflect the European market separately from the US. It also contained Brown-Forman Corporation (BF.B), the maker of Jack Daniel’s, Southern Comfort, Canadian Mist, Korbel Champagne and many others.

It also included American International Group (AIG), Goldman Sachs (GS), and Bank of America (BAC) which you may have read about in recent books or on the web and about which you may or may not have an opinion.

What if you personally don’t like energy companies? Would it bother you to own Chevron (CVX), Conoco Phillips (COP), or Exxon Mobil (XOM)? Or maybe you don’t like defense when you discover yourself owning General Dynamics (GD) and Lockheed Martin (LMT).

These are just a few examples of which there are many similar ones in the same industries. I am not saying anything about the companies, or my personal preferences, nor am I accusing them of anything. I’m just mentioning their inclusion in the index. The index also contains other companies, some of which I recommend for certain clients when it is appropriate for them. The question is, are they all right for you, and even if they are, is the index buying (or adding) them at the best possible time for you?

Want to know more? Let’s talk, and create a plan that’s right for you and your family.

Technorati Tags: how to invest, index funds, Invest Stock, learning index funds, What to Invest In

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