If the echo chamber of the personal finance blogging community is anything to go by, every man and his dog are investing in index funds.
They provide solid long-run returns and passive income, they’ll tell you. And the diversification they provide means you’ll more smoothly ride the highs and lows of the market.
They are right, of course. Index funds can provide all these things. Solid returns, passive income, diversified risk. It’s an ideal investment vehicle for those pursuing early financial independence.
But while I’ve written extensively about my need to double down on passive income streams and long-term investment, I just can’t bring myself to do this with index funds right now. I’ll come to the reasons for that in a moment, but first let’s recap for those new to the investing game.
What is an index fund?
An index fund aims to track the performance of an underlying index, such as the S&P 500 in the US or the FTSE 100 in the UK. They can be exchange-traded funds (ETFs), which are tradeable on the stock exchange, or they can be professionally managed mutual funds, whereby a provider pools your money with other investors and invests on your behalf.
The focus of this article is equity index funds, and the underlying benefit of such funds is simple: They allow investors to get highly diversified exposure to financial markets, which would otherwise prove infeasible for the day-to-day investor.
The benefits of diversification via index funds
So what, you say? What difference does that make?
As we diversify a portfolio of equities, we begin to reduce idiosyncratic (or unsystematic) risk. Put simply, this is risk specifically associated with companies or industries. It’s the risk that a social media company will continue to lose users, that an oil company will have an oil spill, that a pharmaceutical company will face an expensive litigation case.
It’s also the risk inherent in particular industries. The exposure of financial services to regulatory changes and natural resources to geopolitical changes, for example.
You get the picture. By widening our exposure, we reduce our exposure to this unsystematic risk, and we can continue to capitalise on healthy long-term returns. As I mentioned in a previous article, the typical historical long-run return for a well-diversified portfolio of equities in developed markets is around 7%.
So you can quickly see why so many on the road to financial independence are choosing this option. It’s convenient and straightforward, and it gives ample diversification coupled with the potential for decent returns and passive income.
For super-early financial independence, timing is everything
But you can’t diversify away all risk.
In a super-diversified portfolio, we are theoretically only left with residual systematic risk. This risk is undiversifiable. It’s the risk inherent in the overall market – of recessions, interest rate changes, wars, and other major external changes. And it’s precisely why I’ve not started to invest in index funds yet.
I fully accept the contention that index funds should offer solid returns for all over a long-run horizon of say, 15-20 years. But here’s the problem: at this point, I’m not playing a long-term investing game. I need to get a decent return on investment over a medium-term time horizon to secure my desired early financial independence.
As I haven’t taken advantage of the longest economic upturn in history by investing earlier (I focused on generating passive income from property instead) I now face a dilemma. When is the right time to start my investment journey in equities?
Now isn’t a good time to start betting on the global economy
Index funds almost inexorably correlate with global economic health. And right now, no matter how hard I try, I simply cannot convince myself that the global economy is healthy.
Developed economies have been propped up by fiscal and monetary stimulus across the world. Seeking a reprieve from unattractive interest rates, investors have been driven in their droves to equities, away from their usual choices of bank deposits or bonds.
These investors are likely to be particularly elastic in their demand. What does that mean in practice? It means they’re more likely to make a swift exit at the first sniff of trouble.
There’s also the growing sense that we’re ‘due’ a recession. While there isn’t much science in this, growing psychological sentiments drive markets. Just look at the below graph. Never before has the US economy lasted more than 10 years without going through a recession. We’re already at 10 and counting.
Then there is the question of what follows a recession. If we’ve already exhausted our fiscal and monetary headroom, how can we support a speedy global economic recovery like the last one? My worry is the next recession will drag on a little longer than the last.
Prioritising property over equity index funds, for now at least
Of course, if I could predict economic cycles accurately, I’d already be a millionaire. I don’t know when the next recession will take place or at what order of magnitude. But the global economy isn’t healthy, and I continue to read in amazement when I’m told it is.
For now, I’m invested in property and in equities via my private pensions. There’s not much I can do about the downside risk in the event of a recession, but my passive income yield on property is enhanced by the power of leverage.
Notwithstanding, I’m focusing instead on driving down my mortgage principal to reduce the short-term burden of interest. I’m also accumulating a slightly larger emergency fund to provide a little investing flex when worthwhile opportunities crop up.
So why am I focusing on property for now?
Equities face a more immediate impact in the event of an economic downturn, so this is a question of optimising for value at the right time. But importantly, we also have zero control over their performance in tougher economic times.
Of course, we cannot control the general direction of property values during a recession (which is almost always down). But we can still enhance value by extending or building on what we own. We can adjust our rental yields, or rent out even more space to combat cash flow risk. These yields are less elastic. People always need a place to live.
We just can’t exert that control with equities. That’s not a problem in good economic times, but it becomes a comparable disadvantage in tougher economic times.
Now, for those who contend that early mortgage repayment is financially illogical, I agree. Just read the article I wrote about paying mortgages early a few months ago.
But this financial logic only stacks up when we compare long-term average equity returns with the burden of mortgage interest. I believe current timing makes mortgage reduction a more favourable alternative in the medium term.
Let the good times roll
Once markets have stabilised, I’ll re-evaluate my options. There will come a point when equities offer significant upside opportunities in the face of economic recovery.
Index funds will unquestionably be high on my list when that time comes. They provide fantastic levels of diversification and access to equity markets.
But right now, even though I’d be investing regularly over at least 7 years, I don’t think it is the correct time to start investing in index funds.
Make your own choice on its own merits. Your assessment of economic health may differ from my own. Your investment time horizon may mean you have more downside tolerance.
But don’t, whatever you do, invest in index funds just because everybody else is. That’s precisely the psychology that creates asset bubbles in the first place.