Indexing has been the rage for a few years now. By owning the “market”, investors are hoping significant changes in specific securities and industries are “averaged away” by holding the wide selection of securities represented by the index. In essence, indexing works to protect the investor from what is called “specific investment risks.”
When the overall market falls, indexes, by definition, also fall. This is referred to as systemic risk versus specific investment risks. In the current environment, indexes are falling.
With indexing, it is important to realize that in owning the market the investor believes in the long-term viability of the overall market. Markets move in cycles, so the cycle sometimes moves up and at other times moves down, but the long-term general trend is up.
When the market moves down, it is critical to keep in mind the original proposition that the investor believes in the market’s long-term viability. Historically, many investors let themselves get dragged into the “doom and gloom” of down cycles. This results in many selling out when they should just be holding or adding to their index positions. The result could be losses, if their average per share cost is higher than current prices.
It is critical that indexing investors “stay the course” and hold on. A big part of this is controlling emotions. Emotions fall under the area of “behavioral finance”. Not letting the near term market actions get emotional control of the investor is critical to long-term success. Unfortunately, many investors DO let their emotions override rational thinking and, thus, suffer the consequences of selling out at EXACTLY the wrong time.
Remember, that when the market significantly drops, it can stay down for a period of time. No one knows how long that period will be, but it is generally less than five years. But, when the market recovers, it is usually very strong and significantly behooves those who have held through the downturn.
Look no further than March 2020 when the market dipped significantly. Investors who sold out and didn’t get back in didn’t participate in the huge upswing for the last two years. Also, remember such a quick turnaround, as it happened in 2020, is far from the norm (very short). A good mental preparation (behavioral finance) is not to expect a recovery for several years and plan to stay the course.
While historically some indexing investors will sell out when they let their emotions take control, those who hold on or add to their positions (at lower prices) will greatly benefit when the “sun shines again”. Having emotional control in conjunction with rational thinking will protect the indexers from poor results.
The most basic premise with indexing is that the investor believes in the long-term viability of the market. DON’T ever forget that premise!
Be smart, be well-read, be aware and be successful.
