For unsophisticated investors, buying shares in an index Exchange Traded Fund (ETF) can be one way to gain exposure to the broader stock market, without taking the time to pick and choose stocks, which can be a very time consuming process for the enterprising investor.
Iconic investors such as Warren Buffett have recommended index ETFs for most unsophisticated investors unsure of where to begin, due largely to the fact that it has been statistically proven that actively managed funds cannot outperform the broader index, yet the fees charged for actively managed funds tend to be multiples of the fees of the average index ETF.
Most index ETFs are constructed in a weighted fashion, meaning the holdings of an index fund are typically weighted toward how large a given company is relative to the entire index. In other words, the larger a company gets (think Apple Inc.), the larger the percentage of the index this company will make up.
As the largest companies in a given stock market grow to become a larger percentage of the overall market, index ETFs become inherently tied to the fate of a small number of stocks, and the fallacy of gaining diversification through index ETFs begin to shine through.
The fact that the companies represented in most index funds are not equally weighted can cause situations in which the average stock is decreasing while a few of the largest market cap stocks continue to increase, resulting in an investor seeing gains in his or her index ETF despite an overall decline.
In these difficult economic times, it may pay to pick a few individual stocks and incorporate these into a portfolio to avoid the lack of diversification index ETFs are intended to protect against.Invest Wisely, my friends.