Modern portfolio theory suggests that markets are efficient, and that a security's price includes all available information. The suggestion is that active management of a portfolio is useless, and investors would be better off buying an index and letting it ride. However, stock prices do not always seem rational, and there is also ample evidence going against efficient markets.
So, although many people say that index investing is the way to go, we'll look at some reasons why it isn't always the best choice. (For background reading, see our Index Investing Tutorial and Modern Portfolio Theory: An Overview.)
1. Lack of Downside Protection
The stock market has proved to be a great investment in the long run, but over the years it has had its fair share of bumps and bruises. Investing in an index fund, such as one that tracks the S&P 500, will give you the upside when the market is doing well, but also leaves you completely vulnerable to the downside.
You can choose to hedge your exposure to the index by shorting the index, or buying a put against the index, but because these move in the exact opposite direction of each other, using them together could defeat the purpose of investing (it's a breakeven strategy). (To learn how to protect against dreaded downturns, check out 4 ETF Strategies For A Down Market.)
2. Lack Of Reactive Ability
Sometimes obvious mispricing can occur in the market, but in a broad market value weighted index, exposure to a mispriced stock or sector may be minimal. Active management can take advantage of this misguided behavior in the market. An investor can watch out for good companies that become undervalued based on factors other than fundamentals, and sell companies that become overvalued for the same reason.
Index investing does not allow for this advantageous behavior. If a stock becomes overvalued, it actually starts to carry more weight in the index. Unfortunately, this is just when astute investors would want to be lowering their portfolios' exposure to that stock.
3. No Control Over Holdings
Indexes are set portfolios. If an investor buys an index fund, he or she has no control over the individual holdings in the portfolio. You may have specific companies that you like and want to own, such as a favorite bank or food company that you have researched and want to buy. Your portfolio can be augmented by adding specific stocks you like, but the components of an index portion are out of your hands. (To learn about socially responsible investing, see Change The World One Investment At A Time.)
4. Limited Exposure To Different Strategies
There are countless strategies that investors have used with success; unfortunately, buying an index of the market may not give you access to a lot of these good ideas and strategies. Index investing will give you diversification, but that can also be achieved with as few as 30 stocks, instead of the 500 stocks an S&P 500 Index would track.
If you conduct research, you may be able to find the best value stocks, the best growth stocks and the best stocks for other strategies. You may be able to provide yourself with a better-positioned portfolio than the overall market, or one that's better suited to your personal goals and risk tolerances. (To learn more, read A Guide To Portfolio Construction.)
5. Dampened Personal Satisfaction
Finally, investing can be worrying and stressful, especially during times of market turmoil. Selecting certain stocks may leave you constantly checking quotes, and can keep you awake at night, but these situations will not be averted by investing in an index. You can still find yourself constantly checking on how the market is performing and being worried sick about the economic landscape.
On top of this, you will lose the satisfaction and excitement of making good investments and being successful with your money. (To learn more, see Create Your Own U.S. Equity Portfolio.)
There have been studies both in favor and against active management. Many managers perform worse than their comparative benchmarks, but that does not change the fact that there are exceptional managers who regularly outperform the market. Index investing has merit if you want to take a broad economic view, but there are many reasons why it's not always the best route to achieving your personal investing goals.