Portland, Oregon asks…
I’m thinking about keeping it simple with my investments. i.e., self-managing and just buying an index fund. A friend told me to look at the index fund for the S&P 500, and he mentioned just buying the ticker SPY. You’ve long advocated to buy-and-hold stocks for the long-term. SPY gives me broad equity exposure and diversification. What am I missing?
Thank you for your question, it’s a great one. Let me first say that you’re absolutely right—I do advocate owning equities for the long-term, pursuant to your risk tolerance and your need for growth. I’d argue ‘til the sun comes up that equities are the best asset class for the long-term growth investor, hands down.
But, I don’t actually argue for a simple ‘buy-and-hold’ strategy. In the equity division at Zacks Investment Management, we manage for multiple styles and constantly adjust our sector weightings and individual holdings striving to gain a competitive advantage over the index. We don’t want to be the benchmark; we want to beat the benchmark. Doing so requires (often very challenging) tactical decision-making on multiple levels, and constant analysis; something you won’t get from simply buying an index fund.
There are also risks to just going-out and buying an index ETF, like the ticker SPY. First off, buying a broad market ETF might over-expose you to high-risk sectors. For example, during the tech bubble, the Technology sector went from less than 15% to nearly 1/3 of the index. Similarly, in 2008, the Financial Services sector made up roughly 20% of the index. Therefore, for an investor seeking diversified sector exposure, they were really putting the bulk of their investments in one sector. When the bubble burst, the Technology and Finance sectors suffered the most making this not a particularly diversified/risk-resistant investment. It is important to keep in mind that investors do not have control over the sector exposure they receive with these indexes. Coincidentally, the last two bear markets were caused by the Technology and Finance sectors respectively. These are things to keep in mind.
A second risk is less obvious. In order to obtain the equity-like returns some ETF’s are designed to produce, an investor has to unwaveringly stick with them, steel-nerved over the long-term. But, investors notoriously overestimate their ability to keep cool during volatile times. Behavioral finance has shown that investors loathe losses about two-and-a-half times more than they enjoy gains. When the market is experiencing intense selling pressures, there’s a good chance an investor will buckle under the pressure and get out. But, doing so defeats the purpose of owning the ETF in the first place, as the investor has effectively turned a passive strategy into an active one. An active strategy of buying and selling an index fund, in my view, means increasing the likelihood of underperforming over time. And that’s the opposite of what you want.
A final question to ask yourself is: if you owned SPY in 2007–2009, and watched your account value fall by more than 40%, would you have held on? If the answer is “no,” or even “probably not,” then I’m not sure the index approach is a good one for you.
Disclosure