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4 Common Misconceptions About Index Investing

David Ning

Index investing can be a tricky topic to tackle at parties, but I love telling people about the strategy because I want my friends to benefit from their money working for them with less stress than investing in active strategies. I admit it can be tough, though, as the conversation can sometimes turn people away. After all, many people develop misconceptions about index funds and have written them off as an efficient way to build wealth. I outline a few common misconceptions about investing in index funds below. How many of these have you heard?

Index investing produces average results. Many people mistakenly believe index funds just offer average returns, no doubt because they remember claims that every dollar that outperforms is equal to every dollar that underperforms. In reality, though, index funds consistently outperform most mutual funds with the same investment style, and the results get better as the time measured lengthens. When you consider that there are significant opportunities to minimize tax costs with index investing, you are likely to manage above-average returns.

Index investing equals passive and boring investing. Many people are better off regularly plowing cash into the funds and never looking at the balance for decades, but investing in indexes doesn't have to be passive and boring. For instance, you can actively trade exchange-traded funds that track indexes, even though most people will end up losing their shirt this way. You can also eke out a bit more return with index investing by rebalancing, tax-loss harvesting and even being slightly more aggressive (or conservative) by tweaking the asset allocation when valuations are at extremes.

Indexes are fundamentally flawed because expensive equities naturally carry more weight, guaranteeing underperformance. It's true that a large-cap stock can affect the value of an index more easily with the same percentage change than a small-cap stock, but there's a good reason for this. A big company simply earns more money than a small company. Market valuations gyrate rapidly in the short term, but long-term returns are based on the earnings of the underlying company. When you believe returns are higher once every company in an index has equal weight, you are simply arguing that mid-cap and small-cap stocks will outperform large-cap stocks. It may happen, but it may not. And if you want to bet on this, it's simply cheaper to overweight small- and mid-cap indexes.

Overachievers shouldn't settle for mere market returns but should try to beat the market with active funds. We've already established that you can achieve above-average performance with index investing, but here's the kicker: Active investing, even if you can beat market returns, will take significant time. That's time you can instead spend thinking about tax-reduction strategies, or time you can use to set up a part-time gig, or time you can use to further your career. There's only an ultra-slim chance you can actually outperform the market. If you factor in the extra money you can gain by using the time active investing requires to further your finances in other ways, it's practically impossible to argue that active investing will earn you more money than index investing.

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