Stock Portfolio vs. Index Funds

3t253t35You know that your own stock portfolio is as safe as an index fund. But, does it also give you all the upside of an index fund? In actuality, index funds don’t give you all the upside of the entire market, because index funds are not what you think they are.

We will give you an example: the world’s largest index, Standard & Poor’s 500 in the United States is only a limited representation of the US economy. If you look at that mix of industries in the Standard and Poor’s 500, it’s very different from the mix of industries in the actual US economy. And other indexes in other countries are even worse reflections. Because an index is not representative of an entire market, an index fund can’t give you the upside of the entire market.

Secondly, indexes are weighted by company size. That makes them even more concentrated than the true economy. If technology is in favor, they are concentrated towards technology stocks. If financials are in favor, they are concentrated towards financial stocks. That’s against your interests because fashionable industries are inflated in value and typically come back down to earth, leaving you with lower returns. In fact, this weighting of index funds is done mainly because it’s easier to make financial products out of them. Not because it better represents the economy or increases your returns. Since index funds don’t give you all the upside of the entire market they are the same as your own diversified buy-and- hold stock portfolio. And that’s the key point to remember. Whether you pick stocks or pick an index or pick a group of indexes you always make a choice. You will never be able buy the entire market. But, that’s okay because you will never know which parts of the market will do best in advance. Nobody knows that index funds and your own all-stock stock portfolio are the same in terms of upside potential.

So, remember in terms of upside: a buy-and-hold stock portfolio is no better or worse than index fund because indexes don’t really represent the entire market. This is for two reasons: first, the mix of industries in the index fund is different from the real market; and second, the weighting of the stocks doesn’t represent the true market either. Since you don’t know what part of the market has the most upside, picking your own stocks has the same upside potential as a stock index fund.

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