Index Funds and Mental Strength

One of the key characteristics of good long-term investors is drawing the line between making sound investments and emotions. When the stock market crashes, it is common for people to panic and sell off their investments without really understanding why this is happening and being critical as to whether the quality of their investments is still present. Logically speaking, if the quality of the stock has been maintained but the overall market is tumbling, the stock is becoming progressively cheaper. This is an easy concept to understand, but much harder to practice when your life savings are on the line. The emotional element of investing outlines why smart-analytical people can become losing investors. In this article we will discuss why index funds provide emotional comfort when investing in the market, which may be especially important to youth encountering monetary swings for the first time. 

With the correct mindset and investment strategy, managing
your investments can be an enjoyable experience! (source)

Not Trying to Predict the Market

When investing in indexes you are not trying to predict the market. For the most part, you are adding to your investments along the way - at least once a year. By continuously adding to your investment you are reducing variance over the long term. For example, if a given index is down 5% a certain month, through monthly contributions you are lowering your average cost per unit. Not trying to predict the market also means you do not hold off on adding to your investments because the market seems expensive. Even if the market is at a 5-year high, if you choose to hold off on contributing to your portfolio waiting for it to drop, you are somewhat trying to predict the market! What if the market remains relatively stable for the next five years? What if it rises another 20%, or what if it drops 20%? How will you know if it will not drop another 30%? Money is better invested and contributing to dividends since market dynamics are excessively complicated and impossible to predict over any extended period of time. Following the same principle, if you are about to contribute to your investments but markets are tumbling, is it worth waiting? The concept of trying to predict the lowest an individual stock will fall is referred to as 'catching a falling knife'. No one knows how low it will reach and if you misevaluate, you might get cut. This principle somewhat applies to index investing. If you are worried about the state of the market, you could choose to contribute your money in smaller amounts and more often instead.

If you are limited in your ability to add to your investments, another potential strategy would be to keep a certain (but small) percentage of your portfolio in cash, say 5%. This may be a more legitimate strategy to investors buying individual stocks as by the nature of their investments, their portfolios will be less diverse. Meaning it is more likely for a market crash to impact all your investments, versus an index investor than has money in foreign markets and bonds. Having a fix cash allocation gives you the flexibility to buy cheaper units of stocks or index if markets slump. For Index investors, owning bond indexes in your account that provide more stable returns and still give you buffer to rebalance may well be a better strategy. 

You Cannot Blame Yourself for Swings

One of the benefits of owning a well-balanced index fund portfolio is that the swings will be much smaller as compared to owning individual stocks. When substantial swings do happen, it will be because of global market dynamics that no one could've predicted accurately. This means that as an investor, you should be rather emotionless towards swings. You cannot be down at yourself for your recent stock purchase, since you've bought the whole market! By having your money invested in indexes, you are giving yourself a chance at experiencing greater returns than fix investments and keeping ahead of the inflation curve. On average you are making a winning investment. The greatest swing the DJIA experienced in the last 10 years was 7.87% in one day (which is a massive swing for an entire market). If you had 30% of your portfolio allocated in the DJIA, you would've experienced a decrease in value of (0.3*0.00787)*100=2.36% in portfolio value (or $236 on a $10,000 portfolio).

Another key characteristic that distinct index investing versus common stock investing is the risk assessment of losing your entire capital. Assuming that the company managing the index is reputable (such as Vangaurd, BlackRock, banks etc.), it becomes effectively impossible for an index portfolio to go bust. You would need major governments (provincial and federal) to fail to meet bond payments and all major companies to go broke, both domestic and international. Taking the concept of 'too big to fail' to a whole new level.

Remain Realistic About Your Investments
Regarding the mental game, it's also important to be realistic about market returns and understanding that investing in index funds requires a long-term outlook. It's very possible that you could lose money on your investments over some period of time, this does not mean you are making bad investments! Markets fluctuate year-to-year, but do go up on average. Keep a long-term outlook and continue to lower your average cost per index unit during index slumps.

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-Yinvestors.


keywords: index investing, index funds, mental strength, market dynamics, e-series, index funds.