• A narrow target. By this we mean index funds invest only in those securities that are part of the index they are imitating. An S&P 500 fund, for instance, invests only in the large companies that comprise that index. This means such a fund owns no small companies or foreign stocks. When large company stocks do well, so will an S&P 500 index fund. When stocks of small companies are in favor, an S&P 500 index fund will be a relatively poor performer compared to a Russell 2000 or Wilshire 4500 index fund.  

To help counteract the “narrow target” problem, Sound Mind Investing’s Just-the-Basics strategy uses several funds, including those that invest in small companies, foreign stocks, and bonds.

Indexing isn't an all or nothing proposition. Many investors, including sophisticated institutions, invest 50%-75% of their money in index funds, using them as "core" positions to anchor their portfolios. With the rest of their investments, they can venture into "beat the market" type strategies.

These investors know that even if some of their more adventurous holdings go awry, they can rely on the indexes to keep them close to average (i.e. matching the market). In investing, being average isn’t always such a bad thing.  

Published June 10, 2009.

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