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Index Funds: Are They Really Passive Investing?

Index funds are–and probably will continue to be–the easiest way for an average Joe to invest. But contrary to popular belief, they’re not a “set and forget” type investment.

With index funds, you still have to:

Decide Which Index Funds to Use – Most people think of the Vanguard S&P 500 fund when they talk about index funds, but there are actually over 1,000 index funds we can invest in.

Worry About Asset Allocation – Perhaps more important than the right fund is to have the right mix of investments for your overall portfolio. Spending some time doing so is crucial, especially if possibly retiring someday is important to you.

Remember Rebalancing401(k)s are great in that they allow you to automatically rebalance your portfolio without intervention. Too bad none of the other accounts allow you to do that! Though it’s not hard, the process still takes time.

Consider Fees and Choices – Once you dig deeper, you will find that there are multiple funds tracking the exact same index, all with different fees and performance. While I highly recommend going with the most popular fund that has the lowest fees, it pays to know the differences of how they manage to mimic the performance of an index.

Where to Buy It – Vanguard has its own web portal, but you can generally buy most index funds with pretty much any brokerage account. Pick the one that you are comfortable with, and if at all possible, try to simplify your finances by having as few accounts as possible. Otherwise, more time keeping track!

Which Account to Buy It In – Finally, some index funds are more tax friendly than others. For example, REITs are particularly tax-inefficient, so it make sense to put them in tax-sheltered retirement accounts.

Essentially, most of the questions you need to answer for mutual funds apply to index funds too. You may mistakenly believe that index funds are a form of passive investing. But for completely carefree wealth building, you’d need to outsource your portfolio management to a competent financial advisor.

This is a guest post from MoneyNing, who writes about sensible personal finance tips every day. Check out his blog to learn the art of protecting your wealth.

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Comments

  1. So imagine that you are an Argentinian and you could invest in an index fund of governement debt (which has defaulted numerous times)!! Can’t call that passive can you?

  2. In addition to those practical matters, deciding how much attention the average person is best advised to pay to their index funds is a difficult balancing act.

    While I wouldn’t go as far as some voluble commentators, I do believe keeping one eye on the market for extremes of valuation in different asset classes can be worthwhile, especially if you’re following an asset allocation plan as opposed to being 100% in stocks through thick and thin.

    But as we’ve discussed many times, ‘some attention’ is likely to ramp up into ‘over trading’ or ‘rampant market timing’ – I’ve seen this for myself, let alone with a more casual investor who is not aware of the dangers.

    Also, as Mike has often written, it’s very difficult to pay attention without getting bombarded by emotional messages from the media.

    For every Argentinian default, there’s a dozen non-stories (ten dozen?)

    I am still thinking out this one. Personally, if someone asks I still suggest cost averaging into an index fund and ignoring it, but whether there’s a middle way for slightly more interested investors – my jury is still out.

  3. I do believe keeping one eye on the market for extremes of valuation in different asset classes can be worthwhile, especially if you’re following an asset allocation plan as opposed to being 100% in stocks through thick and thin.

    Agreed. I’m just hung up on exactly how to implement such a strategy (How extreme do valuation levels have to become? How far from your originally planned allocation are you willing to stray?) and how to explain such a strategy.

  4. I kind of agree that there’s no such thing as truly passive investing, since you have to do some work to get started, and make small adjustments. And, of course, it is a lot of mental and emotional work to block out all of the noise!

  5. “For every Argentinian default, there’s a dozen non-stories (ten dozen?)” – Argentina isn’t the only country to have defaulted.

    Point is again – there is nothing wrong about indexing – but though is it passive in that you do not have to pick individual stocks, it is not passive in that there is still asset allocation decisions to be made…

    hence, i would say indexing is passive, but asset allocation decisions using indexes is not.

  6. I see so many people make mistakes with rebalancing. People want to believe that they can set it and forget it but then when stocks (usually it’s stocks) have a big run up or a big drop, people don’t adjust and the end up way over exposed. Then they wonder why their ‘passive’ investing isn’t working right.
    A big thing you need to keep an eye on if you are doing it yourself is transaction costs. This could be a decision maker for ETFs vs mutual funds because when you go to rebalance the transactions costs could be quite different. ETFs are charged as a stock trade and mutual funds usually have ticket charges incurred by the transaction. Don’t forget rebalancing usually means selling part of a position (cost?) and buying into another (cost?). Two separate charges?

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