Some people consider themselves hands-on investors. They like to spend time researching stocks, comparing companies within the same industry, and reviewing financial data to determine which businesses should have a place in their portfolios.
Then there are those investors who prefer to take the easy way out by putting their money into index funds. Those investors don't have to do a lot of legwork at all.
To be clear, there's absolutely nothing wrong with being one of those investors if that's an approach you're more comfortable with. In fact, investing giant and billionaire Warren Buffett has long said that index funds are a terrific choice for the everyday investor.
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But while there's nothing wrong with loading up on index funds and holding them for the long haul, there are a couple of pitfalls you might encounter if you go that route. And it's important that you recognize what they are.
1. You won't get to beat the market
When we talk about beating the market, we're referring to assembling an investment mix that delivers higher returns over time than broad market indexes like the S&P 500. Since index funds are simply set up to match the performance of different indexes, they're not a good tool for beating the market. So if that's a goal of yours, you'll really only get there by taking the time to put together a portfolio of individual stocks.
But maybe beating the market isn't your goal. And if you're OK with matching the broad market's performance, then index funds are a more than appropriate investment. Before you fall back on them, though, think about what your financial objectives look like.
2. You won't get a say in the companies you own
Some people are passionate about certain issues and want an investment portfolio that aligns with that. One downside of loading your portfolio with index funds is that you won't get a say in the different companies you're buying.
So, let's say you're an environmentalist who's opposed to some of the practices certain energy companies maintain. Well, if you buy index funds, those same companies might land in your portfolio. That's something you'll have to make your peace with, or otherwise go a different route.
Should you rely on index funds alone?
If you're saving for a far-off milestone like retirement, then index funds could be a smart bet -- especially if you're not a very experienced investor and really don't have the desire to become one. At the same time, though, there are certain drawbacks associated with index funds, so you may want to consider a strategy that focuses on just not these funds, but also, a few carefully selected individual stocks.
However, if you're honest with yourself about the fact that you're really not going to start researching stocks, then you're better off sticking solely to index funds than buying shares of individual companies at random. So think about how much time and effort you're willing and able to put in before making that call.
