Indexing has always been peddled as a cheap, tax-efficient and safe way to get market returns. While it is unquestionably the cheapest and among the most tax-efficient ways to invest, safe it is not, the research shows.
Here’s why: while indexing generally allows investors to diversify individual company risk and still get 100% of the market return, it also exposes investors to 100% of the market’s volatility. And, as we know, volatility is toxic to long-term performance. What is known as ‘volatility drag’ – the exponential recovery needed to offset losses (e.g. you have to gain 100% to recover from a 50% loss) – is the primary culprit for the high cost of volatility and it is part and parcel of getting such direct market exposure. . .
This is an excerpt from our article “Volatility Drag: Why a rigid investment model may be hazardous to your wealth” published September, 2012.