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What is Self-Cleansing of Index Funds

Invest Like A Woman

Let’s talk about cleansing. Not the type where you drink kale juice for three days and walk around grumpy. I’m talking about a unique benefit of investing in index funds – its ability to self-cleanse.

What is an index

Let me explain.  An index fund tracks the performance of a specific index.  An index measures the performance of a large group of assets of similar types (such as stocks, bonds, currencies, cryptocurrencies, or commodities).

For example, the S&P500 is the most commonly followed U.S. equity index.  It measures the performance of the 500 largest blue-chip companies in America.

A special committee selects the index’s components based on various factors, such as the company’s market capitalization, liquidity, financial viability, length of time publicly traded, etc.

Self-cleansing of index funds

What constitutes the 500 largest companies in America is fluid and changes over time as new companies move up, and others fail and fall below a certain market capitalization. As new companies grow, prosper and go public, they replace the dead and dying.

Let’s take a look at the top 10 companies of the S&P500 today and 40 years ago:

 

Do you see any resemblance?  Not a single company on the list from 1981 is currently in the top 10 companies of S&P 500 today.

Even worse.  If you invested in Kodak in 1981, I hope you took a picture of your money because you would have lost a lot of it.

The probability of incurring a catastrophic financial loss is a major difference between investing in individual securities and being an index investor.

If you pick individual stocks, you have to devote a lot of time and effort to analyzing the company’s performance, its competitive position in the industry, and the state of the industry overall.  Moreover, your downside risk is 100% – you can potentially lose all of your money if the company goes bankrupt!

In contrast, as an index investor, I do not have to worry about any individual company.  I trust the process of self-cleansing – the leaders will stay in the index, and the losers will be filtered out.

Aside from the fact that I don’t need to spend much time and effort investing, I am not exposing myself to the risk of a catastrophic financial loss.

Want to dig deeper?

Self-cleansing is only one of the benefits of investing in index funds.  Curious to learn more?  Read our post “The Beginner’s Guide To Index Investing”.

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