Index Fund Investing has a Dirty Little Secret
Don’t get me wrong.
Its better than speculating or gambling.
If you absolutely have no other choice, it may be the way to go.
(If you must index, consider buying the index after a market crash and selling it at the market peak. I acknowledge its easier said than done.)
As always, you should know what you are getting into.
An index fund is an investment in a basket of companies (which companies and how they are chosen is a separate bugaboo of mine).
At the point of your purchase some of these companies are fully valued (i.e. P=V).
Others are undervalued (P<V).
Still others are beginning their plunge into obscurity (P>>V).
Which is which you ask?
You would have to go over each business in order to understand the answer to that question.
But it doesn’t matter.
Because you buy the whole basket.
When you buy the whole basket, you buy everything at market price.
You buy the overpriced assets at a premium and the under priced assets at a discount.
When the price (not value, since you don’t know value of several hundred companies each bought at market price) changes, what do you learn about your investment?
Nothing. Absolutely nothing.
I repeat. Because you buy the whole basket!
How do you know when you should sell and when you should buy?
If you agree that you should buy low and sell high as an investor, you must also agree that you cant do this if you cant value the basket.
You are more prone to market hysteria and the craziness of Mr Market.
You will have a hard time knowing when the market is wrong and when it is right.
The balance of fear and greed that Warren Buffet says you must keep in opposition to the market, will know lean toward the market.
There is a much higher likelihood that you will bail at the wrong time and buy in at the wrong time.
I don’t blame you for making this mistake. When the index loses 25% of its value in a plunge, how do you know what to do if you don’t know what the companies in the index are actually worth?
With an index, you don’t have an independent frame of reference like you do with an individual stock (P/V, EVA etc, remember?)
This is the single biggest reason why people investing in index funds don’t make the same return as the index does. They respond to fear and greed the wrong way.
Find a way out of this trap.
Give it some thought.