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Traders work on the floor of the New York Stock Exchange (NYSE) in New York, on Aug. 4, 2016. Victor J. Blue—Bloomberg via Getty Images

Don't Screw Up Index Investing By Making These 3 Mistakes

Aug 10, 2016

For consistently competitive returns, index funds and their ETF counterparts are the way to go. If you doubt that, just take a look at this new Vanguard research paper that lays out the case for indexing and check out the latest S&P Dow Jones Indices index vs. active scorecard, which shows that fewer than 20% of large-company stock funds beat the Standard & Poor’s 500 index over the five- and 10-year periods ending Dec. 31. But just buying index funds and ETFs doesn't guarantee investing success. To do that, you'll also need to steer clear of these three all-too-common indexing mistakes.

Mistake #1: Assuming all index funds are cheap. Since index funds simply buy the stocks or bonds that make up indexes like the Standard & Poor's 500 or Barclays U.S. Aggregate bond index rather than spend millions on costly research and manpower to identify which securities might perform best, they're able to pass those savings along to shareholders in the form of lower annual fees. Lower fees translate to higher returns and more wealth over the long term. That advantage is especially valuable today given the forecasts for lower-than-usual investment returns in the years ahead.

But not all index funds and ETFs are bargains. While many are available at an annual cost of 0.10% or less, others sometimes charge 10 times or more than that amount, according to Morningstar data. For example, one fund, Rydex S&P 500 Class C, levies a whopping 2.31% in annual expenses, prompting this headline on a recent post about the fund on the American Institute For Economic Research's Daily Economy blog: "Is This the Worst Mutual Fund in the World?"

Before you invest in an index fund or ETF, make it a point to know how much it charges in annual fees, especially if you're investing through a broker or other financial adviser. Then don't buy unless its expenses compare favorably to funds or ETFs that track the same benchmark. You can gauge whether you're overpaying by seeing how the expenses of the fund you're considering stack up versus the expenses of the index funds and ETFs that made the cut for the Money 50, Money Magazine's list of the best mutual funds and ETFs.

Mistake #2: Playing the niche index game. The beauty of index investing is that it allows you to easily and inexpensively create a well-balanced portfolio for retirement savings or other money you're looking to invest. For example, by combining just three funds—a total U.S. stock market index fund, a total international stock index fund and a total U.S. bond market index fund (or their ETF counterparts)—you have the foundation for a broadly diversified portfolio of stocks and bonds that can get you to and through retirement.

But many investors fall into the trap of believing that the more bases they cover, the more diversified and better off they'll be. And investment firms are all too willing to oblige them by marketing ever more specialized index offerings, allowing investors to invest in indexes that track everything from wind power and cyber security to obesity and organic foods.

Diversity is a good thing, but you don't want to overdo it. Once you have a diversified portfolio of stocks and bonds, the extra benefit you get from venturing into investments that focus on narrow slices of the market or obscure niches can be minuscule or even disappear, since more arcane investments often carry higher fees. You also run the risk of ending up with an unwieldy and overlapping jumble of holdings that's difficult to manage. And, let's face it, a lot of what's done in the name of broader diversification is really more about riding the latest fad.

In short, the more you stick to tried-and-true index funds that track wide swaths of the market at a low cost and resist the temptation to invest in every new indexing variation some firm churns out, the less likely you'll end up "di-worse-ifying" rather than diversifying your portfolio.

Mistake #3: Using index funds to gamble rather than invest. When the indexing revolution got underway back in the 1970s, the idea was for investors to track the performance of broad market benchmarks like the Standard & Poor's 500 index. The rationale was that since it's so difficult to outperform the market, investors are better off trying to match the market's return as much as possible.

Today, however, many investors see index funds as vehicles that can help them juice performance by quickly darting in and out of the stock or bond market as a whole or making bets on a sector they believe is poised to soar, be it growth, value, small stocks, energy, technology, whatever. ETFs are especially popular with such investors since, unlike regular index funds, ETFs are priced constantly throughout the day and can be traded the same as stocks.

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Problem is, succeeding at this approach requires investors to have the foresight to know where the market or specific sectors are headed. That's a dubious assumption at best. Consider how investors swarmed into tech and growth stocks at the end of the '90s dot.com bubble, confident that double- or even triple-digit returns would continue, only to see shares crash and burn. Or, more recently, how pundits were predicting Armageddon for stocks in the wake of the Brexit vote, only to see the market climb to new highs.

Bottom line: Indexing works best when you use low-cost index funds that cover broad segments of the stock and bond markets as building blocks to create a diversified portfolio that matches your tolerance for risk—and that, aside from periodic rebalancing, you'll stick with through good markets and bad. Remember that, and you'll be more likely to benefit from all that indexing has to offer.

Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at walter@realdealretirement.com. You can tweet Walter at @RealDealRetire.

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