Don’t Invest on Index Funds. Do this instead!

By akohad Apr4,2023

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Index funds are not as good as they seem…

Index funds are a popular choice for many investors who want to diversify their portfolio and reduce their fees. However, index funds are not as good as they seem.

There’s an old saying: “Make your money work for you as hard as you work for it.” When I read that, it changed my life.

— Grant Cardone

Indexes are designed to track the performance of a broad market or a specific segment of it, but they may not capture the nuances and opportunities that arise from varied factors such as growth potential, valuation, dividend yield, competitive advantage, etc.

In fact, they have several drawbacks that can hurt your long-term returns and expose you to unnecessary risks. By not investing on indexes, investors can have more control and flexibility over their portfolio allocation and risk exposure, and potentially generate higher returns than the average market performance.

Here are some reasons why you should avoid investing in index funds:

1. Index funds are not truly diversified

Index funds track a market index, such as the S&P 500 or the Nasdaq 100, which is composed of a weighted average of the largest and most liquid companies in a given market.

However, this does not mean that index funds are diversified across different sectors, industries, countries, or asset classes. For example, the S&P 500 is heavily skewed towards technology and consumer discretionary stocks, which account for more than 40% of its market capitalization.

This means that if these sectors perform poorly, your index fund will suffer as well. Moreover, index funds are mostly exposed to the US market, which may not capture the growth opportunities in emerging markets or other regions.

2. Index funds are passive and inefficient

Index funds simply follow a predefined set of rules to replicate the performance of a market index.

They do not actively select or manage the stocks in their portfolio, nor do they adjust their holdings based on changing market conditions or opportunities. This means that index funds are prone to overvaluing overpriced stocks and undervaluing underpriced stocks, which can lead to lower returns and higher volatility.

Moreover, index funds incur trading costs and tracking errors when they rebalance their portfolio to match the changes in the index, which can erode their performance over time.

3. Index funds are crowded and competitive

Index funds have become very popular in recent years, attracting trillions of dollars from investors who seek low-cost and easy-to-access exposure to the market.

However, this also means that index funds are facing increasing competition and diminishing returns. As more investors flock to index funds, the demand for the stocks in the index increases, driving up their prices and lowering their expected returns.

Moreover, as more investors hold the same stocks in the same proportions, the market becomes more efficient and harder to beat. This reduces the opportunities for active managers and individual investors to find undervalued or mispriced stocks and generate alpha.

4. Most of the stocks within indexes are underperforming

According to a study by Hendrik Bessembinder, a finance professor at Arizona State University, only 30% of stocks listed on U.S. exchanges between 1926 and 2016 generated positive returns that exceeded one-month Treasury bills. The other 70% either lost money or underperformed Treasury bills. Moreover, only 4% of stocks accounted for all the net wealth creation in the U.S. stock market during that period.

The bottom line

Index funds are not a panacea for investors who want to achieve long-term wealth creation and financial freedom. Index funds have several limitations and disadvantages that can limit your returns and increase your risks.

Instead of blindly following the crowd and investing in index funds, you should consider alternative strategies by picking individual stocks that can offer you more diversification, flexibility, efficiency, and edge in the market.

If you have any suggestions to improve my articles, or want certain topics covered. Contact me on social platforms.

Also, your capital is at risk if you invest. Past performance and forecasts are not a reliable indicator of future performance, and this is not intended as investment advice or a personal recommendation.

Finally, you should not make any investment decisions without first conducting your own research and considering your own financial situation.

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By akohad

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