The Achilles Heel of Index Funds

Index funds, the backbone of my #1 Amazon best seller, Money’s Big Secret, has an achilles heel. This article explains what it is and how you can be prepared.

Index funds are automated. They take your money and split it evenly into all the companies or components of the index. For example, if you invest into the FTSE 100 (the top 100 UK publicly traded companies), it’ll put a little bit into each one.

However, index funds are weighted. This means it’ll automatically divide your money proportionately to the size of the company.

For instance, Apple is the biggest company in the S&P 500 (an American index). More of your money will go into it than, say, Walt Disney which is less than a third of the size.

There isn’t anything inherently bad about this. The potential risk – and there is always risk – comes from the automated nature of index investing.

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If everyone is automatically investing into index funds then the biggest companies such as Apple are automatically receiving the largest portion of investments for no reason other than it’s current valuation. i.e. “I’m the biggest so I should get the most”.

Well, what if Apple’s business takes a hit? What if the automatic investments made through index funds are drive the price up artificially high? What if Apple isn’t worth the price we’re automatically giving it?

If this did happen, we’d expect to see a market correction. Someone catches wind and smells a rat. They pull their money out and tell the world. Other investors pull their money out and the price reduces. Yet if everyone is using index funds, then no one is actively looking.

Thankfully, only 20.4% of money is traded into index funds (as of 2014). 79.6% of money flows are controlled manually.

There are still people looking out. And while they may achieve a short-term higher return for doing so (they sell when it’s highest and buy when it’s lowest), we can be comfortable in the knowledge that we can gain similar returns with fewer gambles over the long-term.

As of yet, the achilles heel has not been cut. It would be wise, however, to know that one day it could be. And I would think that the day will come when index funds reach 51% or more of investments.

Download Free guide to Vanguard LifeStrategy Funds

Myth: Vanguard & Nutmeg.com are UK/US Heavy

Anonymous blogger, Simple Living in Suffolk, pointed out some interesting points about the Vanguard LifeStrategy funds in 2014 (before Nutmeg.com went big). These included that they are perhaps not as globally diversified as one thought. He writes, “The UK and the US together makes up over a two thirds of Lifestrategy”.

This isn’t quite true. It would be more correct to say, “Two thirds of companies are listed on UK and US stock markets.”

That is not the same as, “Two thirds of business listed in the Vanguard LifeStrategy funds relies upon UK and US trade”, for these companies are global. Apple for instance, doesn’t just trade in the US. It trades globally – in fact, it makes more money abroad than it does in its domestic country, the US – yet it is listed on the US stock market.

It’s for this reason that in the weeks after Brexit, the FTSE 100 rose but the FTSE 250 sunk. Why? The companies in the FTSE 100 are global – most of their trade is abroad – and the weaker pound meant their profits increased. The FTSE 250 is a better indicator of companies reliant upon British trade, and these declined.

The USA and UK have the largest stock exchange markets. Global companies are attracted to that fact.

Should you rely solely on index funds to grow your money?

As I wrote in Money’s Big Secret, the rich have remained wealthy for over 2,000 years by diversifying. While index funds help you diversify within the stock markets, you should think of them as one income generation tool.

When Tim Ferriss, author of The 4-Hour series, asked Warren Buffett what he should do with his money, Buffett replied, “Stick it into the S&P 500 and get back to work”.

Your job will give you more money then anything else.

Maria Ndeva, author of MoneyPrinciple.co.uk, explained that if there is one statistic you should measure that would reliably give you financial security, it’s cashflow.

Focus on increasing your income and reducing your expenditure and you’re going in the right direction.

Hold 2-3 months of cash. This is in case of emergencies and opportunities. Hold it in the highest interest-bearing account you can find.
Pay off any expensive debts. It is usually the case that debt costs you more than anything you can make in investments. Credit cards are the killer. Use my debt-calculator and figure out how to pay off your debts as fast as possible.
Start a business. Index funds give you 6-8% returns. Starting a business gives you 0-infinite returns. Give it a shot.

I go into much more detail about index funds and investment strategies in my #1 Personal Finance best seller, Money’s Big Secret.

Be prepared to lose everything

From a philosophical point of view and to develop a strong mindset, I always advocate that you should be prepared to lose everything. All your money gone, poof!

Three reasons:

It could happen. Nassim Taleb, author of The Black Swan, explains there are things we will never know. What’s more, we will never know what we don’t know: unknown unknowns. It is perfectly possible that tomorrow all our money will be gone for unfathomable reasons.
It gives you a sense of peace. Epicurus, the ancient philosopher of happiness, extolled the virtue of ataraxia: tranquility. To achieve this, as Hiram Crespo wrote in Tending the Epicurean Garden, one should live a life of balance. Not chase a singular entity. Furthermore, Seneca, the Roman senator, said one should practice poverty. For example, I fasted for a week without food. Doing this prepares you for the worst-case-scenario.
It forces you to think of back-up plans: Again, hold 2-3 months of living expenses in cash. This buys you time in emergencies to find a new job, move country etc. As Sun Tzu’s The Art of War makes it clear that the mobile survive. Have multiple sources of income and develop strong relationships for social insurance.

The high unlikely chance

In the Vanguard LifeStrategy booklet above (green button; free download) on page 3 they show what gains one would have achieved between 1900 – 2015 had their index fund products been available. The lowest return is 6.2%.

Ask yourself these questions:

Do you think the entire world’s population has enough goods and services for everyone to be happy and healthy?
Do you think the world population will grow?
Do you therefore think the world economy will grow in total size?

If you think yes to that the world economy will grow, because not everyone has a decent standard of living yet and also that the world population is growing, then we can be confident that investing into the world economy as a whole, through a vast array of index funds, is a safe bet to grow our money alongside with it. We are investing into the future at the most macro-level that’s available to us.

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