These Mistakes Can Blow an Index Investing Strategy

One of the longest-standing investing debates centers on whether passive or active funds are better. Passive funds have begun to edge out active funds in popularity, as more investors flock to exchange-traded and index funds.

According to Morningstar, actively managed U.S. equity funds reported $238.7 billion in outflows over the past 12 months, while investments in passive U.S. equity funds grew by $268.1 billion.

Index funds have gained a strong foothold in investor portfolios over the last decade. In 2016, index funds accounted for 25 percent of all equity mutual fund assets, compared to 11 percent in 2006, according to the Investment Company Institute. Their appeal is rooted largely in the lower operating expenses, lower turnover and broader market exposure they offer investors.

The potential to match strides with a major market index is another attraction, but research suggests that index investors may not fully understand what they're investing in. In a 2017 investor survey from Natixis, 66 percent of investors said they believe index funds are less risky, while 61 percent said the funds help minimize portfolio losses.

This suggests that investors may not understand that index funds track the up-and-down movements of the index they follow. "In environments like the past handful of years, it's easy to set it and forget it, meaning you buy an index and the markets go up," says Matt Gulbransen, president of Callahan Financial Planning Corp. in Woodbury, Minnesota. "We're at record low levels of volatility so investors think it's easy to invest, but they forget about the principles of diversification, asset allocation and risk management."

Investors don't realize how much risk they're taking until the market drops and they lose money.

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The Natixis survey also found that investors have unrealistic expectations about index fund returns. The average investor needed real annual returns of 8.9 percent above inflation to meet financial goals, a rate of return that, according to Natixis, charts well above those forecast for major market indexes in the coming years.

Although index funds can keep pace with the market, returns may not be consistent, says Jeff DeMaso, co-editor and director of research for the Independent Advisor for Vanguard Investors newsletter. If returns come in below the unrealistic expectations investors have, their portfolios will feel the pinch, and their savings will fall short of their goals. This is why investors favoring an index investing strategy should know where the pitfalls lie.

Thinking short term. Like other investors, index investors are sometimes guilty of trying to time the market. "Many people will try to time when they think the cost of an index fund is low, so they can buy at a bargain price," says David Barr, a Pittsburgh-based certified public accountant and author of the personal finance blog Common Cents Millennial. "What ends up happening is that they think the price has hit a low, then invest all their money at one time but the price continues to go down, meaning they still bought at a higher price."

At the opposite end of the spectrum are investors who hoard cash waiting for the market to drop, only to see the price of the index fund they want to buy soar. In this case, they either buy at a higher price or miss out on earning returns altogether by holding their cash and waiting for the next down cycle. As with any market investment, index investors are better off adopting a mindset of slow and steady wins the race.

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Choosing the wrong index. Brian Jacobsen, senior investment strategist for Wells Fargo Asset Management's multi-asset solutions team in Menomonee Falls, Wisconsin, says the index you choose should represent the investment universe you want to invest in.

"Names can be catchy, but they can also mask what's actually in the index," Jacobsen says. They can be too narrowly focused or include investments you wouldn't want to buy. You'll avoid venturing down the wrong path if you check the index's underlying holdings before you invest.

Your investment time frame, risk tolerance and short- and long-term objectives will determine the right index to choose. You should also understand the difference between traditional index funds and niche funds. A traditional index fund may track a major index, such as the Standard & Poor's 500 index. Niche funds, on the other hand, have a much narrower scope and invest in a specific sector, such as alternative energy.

With niche index funds, a core and satellite approach works best, DeMaso says. "Hold low-cost, broad cap-weighted index funds at the core, then add your niche positions on the side," for broad diversification with "your own added flavors on the edges."

Even then, be prepared for a niche index fund to trail the market, possibly for an extended period of time, DeMaso says. "If you don't have a long-term thesis for why the investment niche should work and you aren't prepared to stick with it through tough markets, then you should probably steer clear of niche funds."

Panicking instead of keeping a cool head. Emotions can affect any investment strategy, but they can be particularly dangerous for index investors anticipating higher returns. "The natural reaction when the market starts to fall is to pull out and protect our money," Barr says. He acknowledges that this may be good advice if you're investing in an individual company or a specific market, but it poses problems for index investors. "Index investing is basically investing in the U.S. economy because you're invested in hundreds of the largest companies that help drive economic growth."

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Acknowledging the market's cyclical nature is vital. When stocks fall, Barr says you should be driving as much money into the market as you did before the downturn to buy things at a discount, rather than letting your emotions rule. Having a clearly defined plan in place for index investments can help curb emotional tendencies, as can turning to a professional advisor for guidance. Jacobsen recommends tuning out market news as much as possible to reduce your anxiety. "Just because you can check the value of your portfolio at any second doesn't mean you should."

Rebecca Lake is a freelance Investing & Retirement reporter at U.S. News & World Report. She's been reporting on personal finance, investing and small business for nearly a decade and her work has been featured on The Huffington Post, Business Insider, CBS News and Investopedia. You can connect with her on LinkedIn and Twitter or email her at rlake0836@gmail.com.