There’s one thing index funds do very well: minimizing risk. When you add a lot of stock variety, it’s easy to protect against bad trends.
Unfortunately, that means you can neither earn much in the short term. It removes uncertainty and places the bets in the long run.
You almost never hear of people who lost money after years of investing in index funds. You may even think it’s not possible to lose, no matter what you do.
What we’ve found is two cases where people end up losing money. They don’t go broke, but they don’t break even either.
Index funds can technically “lose” if:
- The general market goes down and you don’t diversify well enough
- The market goes down and you panic sell. That’s no longer a long-term strategy
But because the risk is so low, if you ever lose your investment, it will likely be a tiny loss. You’re much more likely to make money or at least break even.
Can You Lose Money in an Index Fund?
That doesn’t mean index funds are for everybody. Because you need to use the right investment vehicle to reach your goals and expectations.
Yes, you can do index funds. But you might be paying an opportunity cost when there are other, much faster investment types. An index is only the right choice when your goal is to stay rich.
If you aren’t yet, then it can look like a waste of time to wait years for small returns. If you can recover from losses quickly, it makes sense to increase risks and rewards.
But even with the perfect strategy, there are downsides with index funds:
- You cannot dramatically increase your return. If you bought a great stock, you no longer get ROI if you also bought the same amount of a bad stock. One big winner doesn’t fix ten losers.
- You have too much variety. Diversifying means having around 5-30 different assets to protect from uncertainty. You won’t make as much as if you only bought one, but you protect yourself from intolerable risks.
When investing in the S&P 500, for example, it’s impossible to know everything about your assets. You can try to study the stocks where you invested the most, but you can’t track 500 companies (and therefore can’t get all the opportunities).
- You might lower your standards. Index funds teach you to not worry about the short term by diversifying. It seems the strategy is to keep “throwing at the wall and see what sticks.” You will eventually find the best stocks. But by that time, you may have already spent too much on the bad ones.
By lower standards, we mean you aren’t as strict when choosing to buy a stock. As long as it has a tiny chance to profit, you buy it. Instead, you’ll earn a lot more if you make fewer but better picks.
- You can’t choose the stocks. You technically choose whether to invest in one index fund or another. But you can’t change the allocation of that fund, because you’re not the one managing the fund.
You may like the overall features of that fund, but what if it includes companies you don’t like? Maybe the ones you want appear included, but the fund company chooses what percentage to allocate. If you want to spend more on it directly, you can’t.
The best option would be to keep an amount of your portfolio on index funds and separately you buy some additional single stocks that you have thoroughly checked out and analyzed.