Index funds are widely viewed as a way for investors to achieve broad, passive exposure to certain markets or asset classes. However, index fund investors may overlook the fact that the creation and maintenance of an index fund entails numerous active decisions. In practice, index providers make many choices that have important implications for the characteristics and returns of the benchmarks they produce. As with any investment strategy, it is imperative for investors in index funds to evaluate whether these choices align with and serve their investment objectives.
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Many people start out managing their own investments. But as their earnings and assets grow, their financial needs and challenges become more complex—and continuing to go it alone could prove costly in terms of investing miscues. Consider three common mistakes that can reduce returns and increase anxiety:
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Holding cash may seem like a safe harbor in the financial markets, providing liquidity and peace of mind. However, this comfort comes with a hidden price – the potential growth you miss out on when your money isn't working for you. With each passing day, your cash reserves could be foregoing valuable opportunities to earn interest, dividends, and capital gains. Over the long run, money market funds (a proxy for cash) have underperformed other fixed-income allocations. Even short-term fixed-income treasury notes have outperformed cash over the long run.
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Financial innovation provides investors with a seemingly endless supply of new investment options. But the process of evaluating the merits of these investments remains the same even as the names change. Adopting a new component in one’s asset allocation represents a tradeoff that should carefully balance the expected benefit vs. the cost of its inclusion. The following framework highlights benefits investors may seek as well as potential drawbacks—a checklist that applies to any investment opportunity.
Properly evaluating whether something belongs in your portfolio begins with specifying the role it is expected to play. These roles come down to a) increasing your expected return or b) helping manage risk.
If the objective is to increase expected returns, what is the case for the asset in question accomplishing that? It is easy to link a positive expected return with equities, for example, as stock ownership gives you a claim on companies’ future cash flows. Similarly, bondholders expect to receive periodic interest payments and the return of their principal as stipulated in the bond’s covenant. But an asset that lacks a sound foundation for delivering a positive expected return should give investors pause, regardless of its past performance.
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No matter how familiar you are with investing, you’ve navigated uncertainty, weighed risks and rewards, and made carefully considered tradeoff decisions. You’ve tackled the central challenges of life — which also happen to be the central challenges of investing.
Having a good investment experience is about more than returns. It’s about how we feel along the journey. Investing should help us live better, more fulfilling lives. By integrating our life and investment philosophies, we can see money as a tool that empowers our plans rather than as a goal in and of itself. Here are six principles that can help us in life and investing.
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