Surprising Facts to Note Before Jumping Into Index Investing
The simplicity of index investing can be a tough sell for those who want to help their friends build wealth. But numbers don't lie -- you can do very well being a buy-and-hold investor. When friends ask me about investing and there isn't a ton of time to explain all the details, I tell them to consider an index fund because it offers the average Joe the best chance of success. Then, I follow up to explain some of the nuances of the strategy. After all, index investing isn't just a set-it-and-forget-it strategy. Here are some of the surprising facts I learned after I became an index investor.
Index investing isn't all that passive. Many believe index investing is a passive approach, but that doesn't paint a complete picture. A prudent investor who decides to invest in index funds still needs to pick an asset allocation, rebalance, tax-loss harvest and continually try to maximize tax advantages. Sure, you can buy a Standard & Poor's 500 index fund and forget about the investment for decades, but there are many opportunities for an index investor to maximize the after-tax return. The beauty of investing in indexes is that you have time to look for these opportunities instead of using all your effort trying to pick the right stocks.
Down years could prove a challenge. Sticking with the plan is much harder than you think during a bear market. That's because the media always portrays gloom and doom during bad times, as the popular sentiment always garners more eyeballs. I remember how practically everyone advised ratcheting down stock allocations after the financial crisis. It would have been good advice if the suggestions weren't given after equity valuations had already crashed. For index investing to work, you have to stay the course through the thick or thin. Otherwise, you are likely going to sell after the market has already fallen and buy after valuations have already bounced back a bit.
That's also why you shouldn't spend more than planned in the go-go years. Part of the reason index investors are successful is because they don't try to time the market. U.S. stocks have roughly managed to return 10 percent annually over the long term, but every year gives vastly different results. You could be down big in some years, but in other years, you could make a killing. On the highflying years, it'll be tempting to spend a bit more because you feel flush with cash, but don't drift too far from your normal spending patterns -- you need all those good years to make up for some of the bad years. Otherwise, your returns will vastly underperform the historical compounded returns if you always withdraw from the portfolio during good times.
Index investing isn't sexy. People cringe when I remind them that no one is going to look up to them when they mention they are an index investor. But you have to be honest with yourself about whether building wealth or looking smart is more important to you. Talking about index investing when people are discussing the prospects of the next hot stock is a conversation killer. After all, buying and holding is boring, and it doesn't sound like a smart strategy. Luckily, the reality is that an index investor is probably the most prudent of them all. Instead of spending time trying to pick the right stock, you are spending the time to look for other ways to boost your returns. Tax savings, risk management or even part-time income are so much more profitable per time spent than trying to beat the market, even if you have a knack for picking winning investments. The results may not be immediately apparent to your peers, but they'll certainly notice your increased wealth through time.
Index investing is a solid strategy, but being able to succeed with these seemingly simple investments requires more than the headline advice of buying and holding. The good news is that this is still the easiest strategy to build wealth. You won't get rich quick, but it offers the best chance to increase wealth steadily through time.
David Ning is the founder of MoneyNing.com .
