Index funds are an incredibly popular way to invest due to their ease of use, diversification, and low fees. Many investors hold their index funds over a lifetime. But are they suitable for the short term investments?
Index funds aren’t good for the short term. They have a slow rate of return and need several decades of maturity to benefit from compound interest. Index funds can also decrease in value in the short term.
If you want to learn just why you shouldn’t hold onto index funds for the short term, read on! Let’s take a look, shall we?
IMPORTANT SIDENOTE: I surveyed 1500+ traders to understand how social trading impacted their trading outcomes. The results shocked my belief system! Read my latest article: ‘Exploring Social Trading: Community, Profit, and Collaboration’ for my in-depth findings through the data collected from this survey!
Table of Contents
Why Index Funds Aren’t Good for the Short Term?
Index funds are an abysmal investment choice if you’re looking to invest in the short term. The reasons index funds make a poor short-term investment choice are:
- They rely on a long period for compounding to take effect.
- Index funds have a slow rate of return on investments.
- An economic decline can heavily impact them.
Let’s look at each of these factors in a little more depth, shall we?
What Is an Index Fund?
An index fund is simply a collection of stocks and shares. Shares are picked automatically by the fund manager, which means that all you need to do is pick the fund and invest your capital.
When you do so, this money is split between the shares that the online broker or the fund manager choses.
You can invest in all kinds of index funds. Popular ones include the S&P 500 and the FTSE 100. With these funds, you invest in every company in either the S&P 500 or FTSE100, in varying percentages.
For example, if company X in the FTSE 100 took up 12% of the market, then 12% of your funds would be invested into company X.
Index funds come with many advantages, offering incredible diversification, for example. Instead of putting your money in a single company, which could fail or fall in price, index funds give you exposure to hundreds, if not thousands, of companies. So, if one company fails, another will succeed, and your money will even out.
Secondly, there are very few fees. Instead of paying an actual stockbroker a considerable cut of your earnings, you’ll be paying an online stockbroker less than 1% to manage your entire fund.
This advantage is compounded by the fact that index funds usually beat stockbroker’s investments!
Index Funds Thrive on Compounding
Compounding is when the money you invest in increases, which means more money invested. So the cycle continues until you have millions and millions lying in your account.
Compound interest can make your rates of return double what they would have been otherwise. But to benefit from compounding, you need time on your side, making index funds a bad choice for the short-term investor.
For example, if you invested $10,000 over five years at an annual return rate of 8%, you’d have around $14,700. So you’re increasing your money by about fifty percent over five years, which is a pretty good return.
However, if you invested the same amount for 45 years, you’d have approximately $319,000. By holding for a more extended period, you’d see a return of 319x your original investment.
As you can see, compounding can make your investment portfolio rise beyond your belief. Unfortunately, short-term investors simply can’t benefit from this type of compounded return, which might just be their major turn off point when considering index funds.
Index Funds Are Best for Long-Term Investors
Compared to some other investment types, such as cryptocurrency, index funds can have pretty sluggish rates of return.
An index fund in the S&P 500 will average around 8% interest a year over a long period. However, as a short-term investor, you’re most likely looking to make a lot of money fast, and this figure just might not cut it.
Index funds are undoubtedly the tortoise in the investment race, so they’re probably not the best choice for those who don’t want to go ‘slow and steady.’
However, over the long run, index funds have proven that they can beat the market’s rate of return. So, as a long-term investor, index fund investing will keep you in the race, and you might just beat everyone else. Slow and steady wins the race, as they say.
Index Funds Are Susceptible to Economic Declines
Short-term investors are incredibly susceptible to economic crashes, which could cause them to lose a lot of money.
Index funds are in no way immune to these crashes, which is another reason why they’re a poor choice for the short-term investor. For example, in 2020, Vanguard’s S&P 500 index fund dropped by over 30% due to the pandemic. The price of this fund took many months to recover, and this is when it recovered much faster than one would have expected.
The effects of economic crashes are negated in the long run, as the economy generally bounces back and grows with time.
But the short-term investor has little or no time to ride out these economic declines. Not only does this make short-term investing as an approach extremely risky, but it also proves that index funds are a terrible idea for the short-term investor.
You’re essentially risking significant losses for very slow growth. So other investment choices such as individual growth stocks make much better sense for short term investors.
Pros and Cons of Index Funds
No matter whether you’re a short- or long-term investor, index funds come with their pros and cons. Discussed below are the most prominent of these advantages and disadvantages.
Pros of Index Funds
Listed below are the primary advantages of investing in index funds:
- Easy to manage. You don’t have to be an expert in investing to invest in index funds. Index funds take all of the hassles of research, technical analysis, and constant obsessing over the price of shares to make an informed decision. All you’ll have to worry about is how much you want to invest and when.
- Low costs. You could go to a stockbroker who’ll cherry-pick some of the best stocks they ‘predict’ will increase value. However, you’ll be paying ridiculous fees, and realistically, you won’t make much money from your efforts. The cost of index funds, however, is so small you likely won’t even notice them. So, they’re a great money saver!
- Great historical return. Of course, history is no indicator of future performance. However, past data has shown that, on average, an index fund investor has a return rate of around 8% per year. For minor work on your part, this is a great return, especially for long-term investors.
- Diversification. Index funds will pick various stocks across various sectors, meaning your money is hugely diversified; therefore, they’re more immune to crashes in specific industries or individual companies. This is the reason for the high average rate of return.
Cons of Index Funds
Listed below are the primary disadvantages of investing in index funds:
- Lack of choice. An index fund heavily limits your input. This can be detrimental for several reasons. First, it stops you from growing your knowledge of the stock market- index funds encourage laziness over education. Second, index funds won’t allow you to capitalize on opportunities. This is a severe drawback to the short-term investor, as some of the best investments you can make are undervalued companies.
- Long haul. Index funds are, by nature, designed for the long-term investor. You’re not going to be able to grow your money without time or realistically withdraw cash in an emergency. To receive the benefits of index fund investing, you’ll need to lock your money up for decades.
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Conclusion
Index funds aren’t suitable for the short term. Short-term investing carries a lot of risks, and you’re probably not going to receive a whole lot of reward. If you’re looking to invest in the short-term, you may just be better off investing in other forms of investment. For example, cryptocurrencies and penny stocks can double in value in a matter of hours.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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