Playing with FI/RE - The Dangers of Investing ONLY in Index Funds

Playing with FI/RE - The Dangers of Investing ONLY in Index Funds

December 9, 2019

I have said it before, and I will say it again -

Time in the Market beats Timing the Market.

And

Keep it Simple, Stupid

Unsurprisingly, this means I am a pretty big proponent of investing in index funds or ETFs. They can hold all of the stocks in the world, the United States, the S&P 500; Basically any basket you can think of!

However - After watching the new Financial Independence documentary “Playing with FIRE” - I am worried that there is an entire population of people that are blindly dumping their money into index products without understanding the risks that they are taking.

So this blog post is to highlight some of the pitfalls of indexing, things to look out for, and a potential remedy.

Similar Article: The RISKS of Investing in ETFs

We will run through 3 of the major risks that plague indexing:

1. Liquidity
2. Diversification
3. Herd Mentality

Liquidity

I was chatting with a fellow personal finance blogger - who I won’t name - and they were talking up their holdings in a small cap index fund. When I asked about liquidity, they came back with: What’s that?

Liquidity is of utmost importance when investing. It is the amount of time it takes to turn your investment into cash. With large cap stocks that trade in large lots often, it is easy to go from stock to cash if necessary.

As you move down the size chain of equities and into other asset classes, liquidity deteriorates - meaning it takes longer to turn your holding into cash. Small caps (small, publicly traded companies) are far less liquid because fewer shares trade daily when compared to mega cap (very large publicly traded companies).

You can check liquidity on the underlying holdings of your index fund by looking at their trading “Volume”.

Volume is the amount of shares traded in a single day of the thing you are looking at and like I mentioned, it decreases generally as you move down company size.

Ultimately, for my fellow blogger, this means that he is invested in an index fund where the underlying securities are highly illiquid. In times of distress - it will be harder for the fund to sell securities and therefore harder for him to sell his holding.

The first rebuttal I would have if I was arguing against myself would be - “But MDAS, we don’t want to be selling our investments when they go down, we want to buy more!”

And that is absolutely correct, BUT if you are holding illiquid securities (or a basket of them), it is hard to BUY or SELL. So this locks us up on both ends. Transacting is just generally harder, and if you ever come across truly tough times or want to rebalance - it may be impossible to trade out of your position.

Moral of the story is to buy assets that are as liquid as possible. This means larger, more highly traded companies and indexes that hold those. For example, Vanguard’s “VOO” ETF which holds a basket of the largest 500 stocks on the market.

Read More:The Difference Between Vanguard’s VTI and VOO ETFs

Diversification

Most people when first introduced to FI/RE just buy index funds and pray for the best because a source of authority told them to.

I say to open your eyes and understand what it is that you are buying, and subsequently decide if it is worth having ALL of your eggs in that basket.

I personally recommend putting money into index funds, so what am I getting at?

High quality Index funds are a great way to diversify your EQUITY holdings, but what about real estate? Bonds? Currencies? Commodities? There are so many ways you can invest your capital - why are we all shoving everything we have into one asset class?

I think a healthy balance of Stocks, Bonds, and Real Estate is a solid foundation. They produce cash flow in the form of dividends, interest, and rent (respectively) and both stocks and RE will likely appreciate in value over the long haul.

So don’t just be diversified in ONE asset class, because that is not true diversification. It is important to hold different assets with different return profiles.

Check this Out:What is the Difference Between Stocks and Bonds

Herd Mentality

The hard thing about understanding herd mentality is that you are surrounded by other people pounding this idea into your brain - so it is hard to have an intelligent conversation with someone preaching a different perspective.

But please hear me out.

Investing is powerful - and index investing has brought about some of the most amazing innovations to the industry - but it definitely has its cons.

I think indexing dumbs down investing to a level where you don’t even need a grasp of fundamental business metrics - and that is dangerous. If you are buying a stock without being able to analyze its cash flow, dividend yield, or price to earnings ratio, how can you understand if you are getting a good value?

Does nobody care about value anymore?

It may be that we know price fluctuates wildly and theoretically at random, so we become comfortable with potentially overpaying at times with the understanding that later we will be buying when stocks are generally undervalued.

However, I believe in this time of over-indexing, we can leverage our BRAINS to think and find business that are truly undervalued. I am not making any investment recommendations, but I am saying that there is opportunity out there if you keep your eyes open.

The main risk with herd mentality is that we are all bunched into one fund - one company - one asset class. What happens if/when that fund/company/asset class implodes? What do we do?

We need to be prepared. I’m not saying you shouldn’t invest in stocks, and if you are investing for the long-haul, indexing is definitely your best option!

I am saying that it shouldn’t be the only cow you are milking at any given time.

You need assets elsewhere that produce cash flow for you - and will even when stocks are capitulating, dividends are being cut, and investment managers are going out of business.

Again, I am not saying this is going to happen tomorrow, I am saying it COULD happen in the future and we should be generally prepared if it does.

Also - what’s wrong with having investment real estate? Or a blog with a few thousand monthly visitors creating ad revenue? Nothing at all. It is just a larger margin of safety for you in times of stress.

So break the herd mentality and invest in yourself, invest in other assets, and continue to invest in the stock market. Just don’t put ALL of your eggs in the indexing basket.

If you are interested in learning how to index - read this blog post:The Glacier Approach to Investing

If you would like to learn more about index funds and their potential dangers - read this blog post:Dr. Michael Burry says index funds are dangerous

Summary

After watching the new Financial Independence documentary “Playing with FIRE” I was both inspired and taken back by how quickly people can jump into a saving and investing mindset.

It inspires me because I love to watch others jump into a healthier financial routine - but it worries me that they may not be doing the research necessary to fully comprehend what they are buying every time they get paid. Just throwing your money into an index fund because someone told you to is, to me, not investing. It is blindly following someone’s advice.

It is generally good advice!!!!!! Owning index funds is a great way to get started investing!

But do your research and continue to learn and become more diversified. You literally can not do that if you don’t understand the environment you are investing in and the product you are buying.

I have a few blog posts on investing that advocate for investing in index funds, specifically those from Vanguard.

I stand by those opinions and still believe they are a great way to gain ownership of American business - but ultimately they shouldn’t be your only investment!

MDAS

If you thought this was helpful, terrible, or somewhere in the middle, please leave me feedback in the form of a Direct Message on instagram @MakeDollarsAndSense, or feel free to send me an e-mail/text to the information on my Home Page. I truly appreciate constructive criticism and opposing views, so bring em on!

P.S. New blog posts coming your way every Monday!

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