Risks and tradeoffs of index funds

Edith B.
July 20, 2022

Of course, as with all investments – and products – there are risks involved. Some products better suit some investors, and all have tradeoffs. In this section, we share with you the tradeoffs and risks associated with Index funds.

Primary tradeoffs of index funds

In our What are index funds? article, we asked Ben Reynolds from Sure Dividend about which asset type suits passive investing more. Here, we share his thoughts about the tradeoff of investing in index funds compared to investing in individual stocks.

“The primary tradeoffs between index investing and investing in individual stocks are diversification versus concentration and time spent researching.

A broad market index fund gives investors significant diversification between individual stocks. But this has the drawback of not allowing an investor to focus on their best ideas or the individual stocks that may be the best fit for them. With index funds, there’s no need to analyze individual securities so it’s typically a much less time intensive investment strategy versus investing in individual securities.

Investing in individual stocks allows for greater flexibility, customization of holdings to match your individual needs, and greater concentration in your best ideas. The benefits of diversification trail off with the more securities you own. The diversification benefits of going from 1 to 30 securities are far, far greater than the diversification benefits of going from 30 to 900 securities. Of course, to invest in individual securities you have to analyze them yourself or have a trusted source of information to find selections. Either way, investing in individual securities is likely to me more time intensive than index investing.”

-Ben Reynolds, Sure Dividend

Risks and tradeoffs of index funds

Risks of index funds

Below, Derek Sall from Life and My Finances is here to share the risks involved with index funds.

“Index investing is a great “set-it-and-forget-it” method. You put your money into something like an S&P 500 index fund where the fees are super low, you’re diversified across hundreds of different companies, and your investment is likely to go up over the long term.

First off, index investing, while diversified, is still the stock market. And, as we all saw with the latest Covid scare, all companies can be impacted and lose their value at once. Your index investments are not immune from tanking. Thankfully, they most often bounce back over time. The key is to not invest for the extreme short term, but for the long term (ie. at least 5 years or more).

The other danger is that over the long term, you won’t make 20%+ annual returns with the S&P 500 index fund. You’ll likely top out at approximately 10%. So, if you’re way behind on your retirement contributions, you may need to invest in something more risky for a potential greater reward.”

-Derek Sall, Life and My Finances

Risks and tradeoffs of index funds

Where to look for more?

Hope you liked this quick rundown on index funds. If you’d like to see more, navigate to one of the articles below:

Risks and tradeoffs of index funds

Primary tradeoffs of index funds

Risks of index funds

Where to look for more?

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