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Index Fund Investing: Gold Standard Or Fool’s Gold?

There is a lot of love surrounding index funds, but is it possible that the love is unrequited?

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Forge Your Wealth is meant for education and entertainment and should not be used for financial advice.

Index fund investing is one of the most popular forms of investing. Almost half of all stock market equities are in some passively managed index fund. Shares in the bond market have even crept over to index funds. Why would that not be the case? Ever since 1926 the S&P 500 index, one of the best model indexes has increased by approximately 10% annually. The past performance of the S&P 500 makes index investing very attractive.

S&P 500 Index
Source: Macrotrends

In addition to mimicking a well performing index, index funds have small expenses, taxes, and according to SPIVA, they have outperformed practically every equivalent actively managed mutual fund over a certain number of years. With the performance of the S&P 500, I have become interested in index fund investing and was searching for S&P 500 index funds. But I have found something interesting. The truth, some index funds may not be as good as people claim.

I have heard people say that the past performance of an index fund does not guarantee future performance. I was not surprised by these claims, that is investing 101. But there are several other claims in which make me question if all index funds are good investments. I will primarily focus on the S&P 500 index fund, but I will also bring up other index funds.

S&P 500 Is Overvalued

Dr. Robert Shiller calculated the price to earnings ratio using his own P/E ratio known as Shiller’s P/E. Shiller’s P/E is applied to the S&P 500. The Shiller P/E is rather high now suggesting that returns of the S&P 500 will be dwindling in the near future. Furthermore, the capitalization of the S&P 500 appears to be higher than the GDP.

Altogether, the future performance of S&P 500 index may be underwhelming compared to past performances.

If One Company Is Overvalued The Entire Fund is Overvalued

Since the S&P 500, a collection of 500 of the largest companies, is overvalued anywhere from one of the companies to all of the companies in the S&P 500 are overvalued.

Investments are overvalued occasionally. But when a collection of what could be individual investments are overvalued, problems arise. If the individual investments are all overvalued then this would be fine, but if only a few or even one investment is overvalued then this overvaluation reflects on all companies in the S&P 500. People may stop investing in the S&P 500 or even pull out some of their money. If this happens then the overvalued company will revert back to healthy valuations. On the other hand, the other companies in the S&P 500 will become undervalued because they needed the cash flow from the index fund to grow. That will further hurt those companies and the S&P 500 index if those overvalued companies stay in that index, which is likely since the S&P 500 kept failing companies like Enron because those companies had a stellar reputation before its fall.

Index Fund Brokers Are Likely To Head The Corporate World

Jack Bogle, the founder of index funds, warned that with more people investing into index funds, the majority of US assets will be owned by the providers of these funds like Vanguard. According to Mondy over 30% of stock market assets are investments from index funds and they may easily exceed half of all stock market assets in the future.

Index funds do not allow shareholders to vote in corporate decisions, but they allow the holders of the funds to vote in these matters. If you want to not only make stock investments, but have control over your investments, index fund investing is not for you.

I have a little money in individual stocks. Even when compared to someone with millions only in index funds I have more control in the corporate world than them.

Index Funds Are Not Very Diversified.

Normally, it would sound like a diversified fund in which tries to follow the top 500 companies is very diversified. That is not always the case. The S&P 500 index in 2018 had “too much” in tech as 26% of the S&P 500 was in the technology sector. The S&P 500 may always be mostly invested in the best performing sectors so you will not get as much diversification as you would think.

Index Funds Are Guaranteed To Take Market Drops

Index funds like the S&P 500 follow an index that mimics markets. When the global economy improves the S&P 500 tends to go up. But that also means that it will go down with the economy. If a recession happens in the near future there is no way to avoid losing value in your index fund.

The Issues Are Not That Big

Many people instantly turn against index fund investing because of these reasons. Personally, I do not think that these issues are major, nor are they unique. These issues are in actively managed mutual funds as well as index funds.

Actively managed mutual funds also deny individual shareholders corporate votes.

Some of the actively managed mutual funds invest in similar companies as index funds and are likely to be primarily invested in one sector. One of the balanced funds I invest in has some of their largest investments in tech stocks. I do not think funds just randomly chose tech stocks, I believe tech stocks are currently performing well and fund managers chose them because of their performance. Either way active funds are just as vulnerable to the swings of the economy as index funds.

As for whether the S&P 500 index is in a bubble, the S&P 500 index is the most popular index in which funds match. It has a market cap of $25.6 trillion so it is likely in a bubble. Any other investment would be too.

Takeaway

Index funds following the S&P 500 are one of the most popular forms of investments ever. They have a long history of satisfactory performance. That being said, I think S&P 500 index funds are just average in terms of long-term investments and is almost hands down the most overrated investment today.

I know that I probably angered many people, but think about it. It is a blend of large cap growth and value stocks. They may continue to grow, but not very fast.

Despite this truth, many people have invested capital into the S&P 500. This is probably what made it overvalued. But this is a perfect example of why going with the crowd when it comes to investing is not the best plan to build your wealth.

S&P 500 index fund investing is not the best way to invest, at least not right now. It has returns in which have stagnated, but the risk remains relatively high.

What About Other Index Funds?

Other index funds such as those involved in small cap investments may still be good, but note they are still popular and will swing with the markets just like the S&P 500. I do not recommend investing in any index fund right before an impending recession. Indexes follow markets so they will fall when markets fall.

There are still many unknowns. Would investing in a completely different index be enough to avoid the trends of the S&P 500? Some indexes that follow small cap companies like the Russell 2000 may be separate from the S&P 500, but the question is if it would be enough. For example, another popular index, the Russell 3000 includes the S&P 500 companies and Russell 2000 companies and the 500 mid caps in between. Many indexes contain other indexes so they are not truly separate.

Final Thoughts

Index fund investing is a new form of investing in the stock market. Its innovation allows investors to start investing in a diverse and proven method of asset growth. This makes it one of the most popular forms of investment ever and also one of the most overrated forms of investment ever.

With less than stellar returns and still more than modest risk, index fund investing is a little more like fool’s gold than a gold standard right now. I know that is the unpopular opinion, but that alone should show that index fund investing is less than stellar right now.

These index funds may revert back, but I do not see S&P 500 index funds being the best investment to make right now. If you have money in an S&P 500 index fund, you should definitely keep your money invested. You may want to find different investments to try to diversify. After all, diversification preserves your wealth during tough times. Index funds may not be the best way to forge your wealth right now, but they may be in the near future.

Author: Papa Foxtrot

Most of my life I was careful with money and learned where I should invest it. I was very lucky to have parents who taught me financial literacy when I was young. Unfortunately, I am very lucky because many people lack the financial literacy I know. The purpose of Forge Your Wealth is to teach people who are just starting out in life how to obtain their wealth or anyone who just realized they may need to learn more to handle their finances. I currently have a PhD in biochemistry, just started a job in industry (will not disclose where exactly for personal and professional reasons) and am currently married to the love of my life. I am one of the lucky few people in America who graduated with no student debts, my wife was not. Over the series of a little over 3 years we paid for our wedding with no debt and paid off her federal student loans.

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