The Illusion of Safety: Index Funds Are Not Low-Risk … If the risk-on euphoria of punters borrowing billions of dollars in margin debt doesn't materialize, stocks could languish for years after falling 50%. The financial service industry's Prime Directive is to exploit humanity's core drives of Greed and Fear. Financial service companies promise high returns (fulfilling our greed) that are low-risk, i.e. "safe" (placating our fear of losing our nest-egg). But the safety of many supposedly low-risk investments is illusory. –LewRockwell
Dominant Social Theme: Index Funds are a work of low-cost genius.
Free-Market Analysis: This is a timely article because it reminds us that in an unraveling market much of the normal Wall Street dialogue is invalidated.
Index funds are part of that larger dialogue, as is modern portfolio theory, asset allocation and asset-class allocation. When you invest in index funds, you are buying a representative sample of a given equity index. The index may or may not be correlated with other funds you own.
But the index itself is likely to have less volatility than an individual stock. Modern portfolio theory shows us that almost all of a given return comes from the asset class not an individual instrument.
When you allocate assets over a series of funds and instruments, you may ameliorate your chances of losses because the business cycle will inevitably raise the performance of some classes and sectors while lowering others.
Wall Street treats asset allocation in a scientific way but it is really not scientific. Asset-class allocation is more scientific because in true asset-class allocation, the fund may have been customized so that every equity instrument in it retains appropriate characteristics – "growth," etc.
Customized asset-class funds are available to institutional investors for the most part while the average fellow ends up "allocated" into already available funds that in many cases may have been aggregated before the Street was even aware of MPT and asset-class investing.
Asset-class allocation has one major flaw: It doesn't offer much in the way of precious metals or commodity allocation. You would think that the hundreds of billions invested into these funds would demand that commodities and precious metals be represented.
But even asset-class advisors are more apt to suggest government securities to ameliorate equity risk. Thus we can see that none of these three variations are as scientific as the securities industry would like us to believe.
Index funds are a lower cost alternative to active funds but ultimately index funds will assume the profile of the rest of the market – moving in much the same direction.
Funds that participate in an asset allocated portfolio will also track the larger market unless they include precious metals, commodities, real estate, etc. Many such allocations of funds have none of these options.
Asset-class allocation is an outgrowth of modern portfolio theory and one can make the argument that such funds, being customized, are more predictable and less volatile. But even asset-class allocations often offer various forms of equity plus government securities. The "hard" alternatives are entirely missing.
There are commissions to be made from stocks and bonds. And Wall Street, too, is a reflection of modern central banks. Central bankers don't like gold and seem not especially comfortable with commodities until they are securitized.
This article posted at LewRockwell.com comments on index funds but it could be commenting on asset allocation or even asset-class allocation, Wall Street's most sophisticated shibboleths.
… What is left unsaid is that if the broad market declines 50%, index funds also plummet 50%. The supposedly low-risk nature of index funds is completely illusory once the entire market tanks. What's also left unsaid is the possibility that the market might not just drop 50%, but that it might not bounce back.
Wall Street has touted various strategies as academically valid when they are not. Another key statement:
Central banks have generated risk-on euphoria after every crash since 2000, but there is no guarantee the bloated balance sheets of central banks and plummeting profits of corporations can support a fourth expansion of manic risk-on borrowing to buy stocks.
Nothing in any of Wall Street's various forms of index investing or asset allocation theories fully – or formally – acknowledges the destructive economic effects of modern central banking. Investors may or may not realize this – even the institutional pros who have their own pressures.
The article concludes, "If this is indeed the last bubble, all those holding onto index funds in the mistaken belief that these funds are low-risk will discover the illusion of safety via devastating losses that can never be recovered."
And those who believe that their "allocated" funds – even funds allocated via disciplined asset-class allocation – are somehow resistant to a broad market implosion will likely be similarly surprised.
Conclusion: To be fully diversified, use common sense and track alternative investment media suggestions that take the full spectrum of available investments into account. At this juncture, the alternative media is apt to be more honest for a variety of reasons.