Index Investing Has a Hidden Problem
Index investing is often seen as a simple way to invest in the stock market. You buy an index, and your money is spread across many stocks. But there is one important issue that investors should understand. When a stock inside the index starts falling badly, an index investor continues to hold that stock because the index still includes it. This means you keep owning a falling stock until the index finally decides to remove it.
Falling Stocks Stay for Too Long
The main problem is that an index does not remove a weak stock quickly. By the time the stock is removed, a large part of the damage may already be done. A stock could fall 60%, 70%, or even 80% before it is finally removed from the index. This means index investing can sometimes make investors stay with losing stocks for much longer than they may expect.
Nike Shows the Problem
Nike is a recent example of this issue. The stock has fallen around 80%, from about $200 to nearly $36. After staying in the S&P 100 for 18 years, Nike is now being removed from the index.
This shows how an index can continue to hold a stock even after its long-term performance has become weak. The stock is removed only after a major fall has already happened.
Indexes Move Very Slowly
Indexes are designed to keep stocks that are doing well and remove stocks that are not doing well. In this way, they are like momentum portfolios. But the problem is speed. Indexes usually rebalance every six months or once a year. Because of this delay, a stock can keep falling for a long time before the index takes action. By the time it exits, most of the damage may already be done.
Yes Bank Is Another Example
The same thing has happened in India. Yes Bank was once part of the Nifty index. But the stock fell from around ₹400 to nearly ₹20 before it was removed from the index. For an index investor, this meant continuing to hold the stock during a huge fall simply because the index had not removed it yet. This is an important risk that is easy to miss when looking only at the benefits of passive investing.
Should Investors Be More Active?
Index investing can give investors broad exposure to the market, but its slow rebalancing process can also create a problem. Investors who want to reduce this risk may need to be more active in watching index stocks and rotating out of stocks that are clearly becoming weak. The key lesson is simple: an index will eventually remove a bad stock, but it may do so only after a large part of the fall has already happened.
