from The Daily Bell:
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.
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