When Do Index Funds NOT Make Sense?

This is a bit of a weird question. After all, index funds are probably the right choice for most investors, most of the time. This is particularly true if you are light on investment experience, or if you prefer investments that are relatively passive.

Still, there are times when index funds do not make sense, and here are a few examples.

If You Are a successful Stock Picker

If you are an experienced investor, with a long track record of picking stocks successfully, you’ll probably find index funds to be a little bit…boring! And for you, they will be. Let’s face it, with index funds you make your investment and then step back and let it happen. That’s perfect for a passive investor, but if you can beat the market averages in most years, you’ll probably feel as if you are losing money by investing in index funds.

Admittedly, very few people can beat market averages on a consistent basis. But if you’re one of the few, index funds will only work if you are looking for some time to kick back and take it easy.

When the Stock Market Is Range Bound

Index funds are a brilliant investment in rising markets. You don’t have to pick individual stocks, figure out which sectors will outperform the market, or even pay a lot of attention to your investments. You buy into index funds, get into the elevator, and ride it up.

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Perfect.

But when the stock market is range bound – when it’s movements are essentially no better than sideways – index funds will be a road to nowhere.

In a range bound market you’ll be far better looking for specific sectors that are rising. Energy funds might be a good example, since the same factors that would cause them to rise might also cause the general stock market to stagnate. You can make far more money investing in energy funds if that is the case. And energy funds are just one such sector.

When the Stock Market Is Looking Top Heavy

When the stock market looks like it’s getting nose bleeds, index funds could be one of the worst places to be. The upside potential is very limited, but the possibility of a slide is much greater. Should the general market begin to fall, index funds will go down with it.

In such a market it might be difficult to identify a sector that will outperform the market and continue to rise. But you can always go to cash, which will protect your portfolio from impending market declines. In a declining market index funds will lose value, while cash will preserve it. Then when the market seems to be bottoming out, you’ll have plenty of cash to move back in index funds for the ride up.

When Interest Rates Are Rising

Rising interest rates usually have a negative effect on the stock market, and that includes index funds. Since interest-bearing assets compete with equities for investor capital, rising interest rates will generally cause a move out of stocks and into interest-bearing investments. The exodus from stocks will make index funds a poor investment.

In a rising rate environment, you’ll be better off in money market funds, very short-term bonds and any other instruments that are likely to benefit from rising interest rates. For what it’s worth, longer-term notes and bonds won’t do much better than stocks and are best avoided too. Rising interest rates can also cause longer-term interest-bearing securities to drop in value. The longer the term, the greater the potential drop.

If You Are Completely Risk Adverse

If you’re looking for low risk investments, index funds aren‘t the place to put your money. Index funds may have lower risk than actively managed funds and most sector funds, but they are hardly risk-free. A 50% fall in the market to which your index fund is attached will cause a corresponding 50% drop in the value of your fund.

If you prefer low risk investments you will be better off investing in certificates of deposit, bonds, and high yield dividend stocks, such as utility stocks. The income provided by the securities will keep them from falling as dramatically as the general stock market.

Index funds are not the all-weather, widows-and-orphans type of investments we sometimes like to think they are. They are an excellent hold for investors who are looking for growth with an average appetite for risk. But for investors who want something more dynamic, or those are more risk adverse, or in certain types of market environments, index funds may not make much sense.

Readers: Do you agree or disagree? Do you know of any other situations in which using index funds doesn’t make sense?