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Should You Index?

Ricky, a former student of mine, landed his first job and wanted to start investing.

He had read a bit about index funds but had more questions.

He was surprised when I said I didn’t care too strongly, as an index fund is just one of many tools an investor can use.

Rick determined index funds are usually quite cost efficient, offered diversity and delivered a simple solution.

I had no argument with his statement, but asked which index funds he would use.

This caught him off guard.

There are dozens, if not hundreds, of index funds. Although many are similar just as many are quite different.

Furthermore, there are index funds designed to give exposure to different sizes of companies, industries, geographies and asset classes (stocks, bonds, real estate, etc.).

Ricky was surprised as the simple solution no longer appeared straightforward.

Further complicating matters, there are many varieties of indices designed to track a certain group. Many are market capitalization weighted (larger companies count more). However, there are also equal weighted indices (all companies get the same exposure).

For those that live dangerously, there are also index funds that use leverage and derivatives.

Ricky didn’t seem to understand. In his mind, the S&P 500 index was universal.

I explained that although there are 500 companies in this index, in a market capitalization weighted index the largest company, Apple, was 4% while the smallest company only equaled 0.12%. In comparison, an equal weighted index of the S&P 500 gives each company a weighting of .2%.

Ricky asked if the difference really mattered.

Indeed it does. Over the past ten years the equally weighted S&P 500 index gained 112% whereas the market cap weighted version only delivered a gain of 76%.

Further complicating matters, I asked Ricky what his goals were. I added he should have different “buckets” of money to serve different purposes.

Everyone should have about 6 to 9 months of living expenses in an “emergency bucket.” You want access to those funds at all times with little to no volatility.

I reminded Ricky that since 1950 the stock market has gained as much as 57% in one year and lost as much as 36% in one year. Given this, it makes no sense to place his emergency money in an S&P 500 Index fund.

Additionally, Ricky mentioned he was saving for a new car. Based upon current driving habits, he estimated the need to buy a car in the next three years. Again, I referenced the shorter term volatility of the stock market and suggested if he needed a car in three years then the S&P 500 Index was an inappropriate asset.

However, if Ricky truly had goals of 10 or more years, and he could withstand the significant volatility of the stock market, then a stock index fund might be appropriate.

At this point, Ricky was ready to go. I told him I had one more question. He grimaced.

I said I had never met someone who wanted a bargain more than he did. Ricky grinned as he wore his badge of “fiscal retentiveness” with pride.

I said, “Great. You’re going to buy an index fund. Are you getting a bargain or paying too much?”

Ricky repeated his earlier statement, “Index funds are cheap to own.”

True, however this says nothing about the value of the underlying assets within the index. As Ricky pondered this he remembered the S&P 500 had fallen more than 50% in 2008 and 2009.

Although management costs to own the index fund are cheap, they tell you nothing about how much you are paying for the underlying assets within the index.

I added that the stock market is currently valued in the 90th percentile, meaning it is definitely at the high end of valuation. Furthermore, stocks across a broad range of metrics show extended valuation.

My point was not to dissuade Rick.

Rather, all index investors must understand that index funds are merely one tool to consider.

You must identify what type of index fund you need and correctly match your investing time frame and cash flow needs. Given this, even a “hands-off” approach requires considerable thought.

Finally, although the management costs of most index funds are cheap, it says nothing about the value of the underlying assets. In considering this, remember the words of Warren Buffett: “Price is what you pay; value is what you get.”

Originally published April 14 2015, Victoria Advocate