Are you thinking about investing in index funds but worried about potential losses? You’re not alone. Many beginner investors wonder: can you lose money in an index fund? The short answer is yes, you absolutely can. But don’t click away just yet! There’s more to the story.
As someone who’s been investing for years, I’ve seen both the upsides and downsides of index funds. While they’re often promoted as safe, low-cost ways to grow wealth, understanding their risks is crucial before you commit your hard-earned money.
Key Takeaways About Index Fund Risks
• Index funds can definitely lose value, especially during market downturns
• Despite diversification benefits, no investment is completely risk-free
• Not all index funds perform identically to their underlying indexes
• Short-term investing in index funds is generally not recommended
• Most financial experts still consider index funds less risky than individual stocks
What Exactly Are Index Funds?
Before diving into the risks let’s make sure we’re on the same page about what index funds actually are. An index fund is a type of passive investment that aims to track the performance of a specific market index like the S&P 500 or the Dow Jones Industrial Average.
When you buy shares of an index fund, many people think you’re basically buying tiny pieces of every company in that index. But the reality is sometimes more complicated.
Index funds are designed to mirror the performance of their underlying index, but they don’t always hold every single stock in that index. Some might use derivatives like options and futures to achieve similar results. Others might provide leverage, multiplying both potential gains and losses.
How Can You Lose Money in an Index Fund?
Despite their reputation for stability there are several ways investors can lose money in index funds
1. Market Downturns
This is the most obvious risk When the market goes down, so does your index fund. If you invested $10,000 in an S&P 500 index fund before the 2008 financial crisis, you would’ve watched your investment shrink to around $5,000 by March 2009. That’s a 50% loss!
2. Fees Eating Into Returns
Even though index funds typically have lower fees than actively managed funds, these expenses can still chip away at your returns over time. A fund with a 0.5% expense ratio might not sound like much, but that’s $50 annually on a $10,000 investment.
3. Tracking Error
Not all index funds perfectly track their underlying index. Some consistently underperform due to various factors including management strategy and fund expenses.
4. Selling During Downturns
One of the biggest ways investors lose money is by panicking during market crashes and selling at the worst possible time. This transforms temporary paper losses into permanent real losses.
5. Leveraged Index Funds
Some specialized index funds use leverage to multiply returns. A “3x leveraged” S&P 500 fund might gain 3% when the S&P goes up 1%, but it’ll also lose 3% when the index drops 1%. These can be particularly risky.
Common Misconceptions About Index Funds
Let’s clear up some myths that might be giving you a false sense of security:
Misconception #1: Index Funds Always Perform the Same as Their Index
Not true! As mentioned earlier, many index funds slightly underperform their benchmark indexes due to fees and tracking errors.
Misconception #2: All Index Funds Are Low Risk
While most mainstream index funds are considered relatively conservative investments, not all index funds are created equal. Some track volatile sectors or use leverage, making them significantly riskier.
Misconception #3: Index Funds Work Well for Short-Term Investments
This is a big one. Index funds are generally designed for long-term investing—think 5-10 years minimum. They’re usually not great vehicles for short-term goals due to market volatility and potential fees.
As Brian Walsh, CFP® and Head of Advice & Planning at SoFi says, “Investing in index funds tends to work best when you hold your money in the funds for a longer period of time, or use a dollar-cost-average strategy, where you invest consistently over time to take advantage of both high and low points.”
How Likely Are Index Funds to Go to Zero?
If you’re worrying about losing ALL your money in an index fund, I’ve got good news. It’s extremely unlikely that a broad-based index fund would ever drop to zero value.
For this to happen, every single company in the index would need to go bankrupt simultaneously. For major indexes like the S&P 500, that would mean 500 of America’s largest companies all failing at once—a scenario that would likely indicate a total economic collapse.
However, significant losses are definitely possible. During the 2008 financial crisis, many index funds lost over 50% of their value. During the COVID-19 crash of March 2020, market indexes dropped by about 30% in just a few weeks.
The good news? Historically, markets have always recovered eventually, which is why index funds are generally viewed as long-term investments.
The Benefits of Index Funds (Despite the Risks)
Despite the potential for losses, index funds offer several compelling advantages:
Diversification
By spreading your investment across many companies, index funds reduce the impact of any single company performing poorly.
Lower Costs
Most index funds have significantly lower expense ratios than actively managed funds, typically ranging from 0.03% to 0.2%.
Simplicity
Index funds offer an easy way to invest without needing to research individual companies or time the market.
Historical Performance
Over long periods, major market indexes have generally trended upward, despite periodic downturns.
Who Should (and Shouldn’t) Invest in Index Funds
Good candidates for index fund investing:
- Long-term investors with time horizons of 5+ years
- People looking for diversified exposure to markets
- Investors who want a hands-off approach
- Those who can emotionally handle market fluctuations
Maybe not ideal for:
- Short-term investors needing money within 1-3 years
- People who can’t tolerate any potential losses
- Investors looking for quick, high returns
- Those who need guaranteed income
How to Minimize Losses in Index Funds
While you can’t eliminate risk entirely, here are some strategies to potentially reduce losses:
1. Diversify Across Multiple Index Funds
Don’t put all your eggs in one basket. Consider owning different types of index funds tracking various markets (U.S. stocks, international stocks, bonds, etc.).
2. Use Dollar-Cost Averaging
Instead of investing a lump sum, consider regularly investing smaller amounts over time. This approach can help reduce the impact of market volatility.
3. Keep a Long-Term Perspective
Remember that index funds are marathon investments, not sprints. Temporary downturns are normal and expected.
4. Choose Low-Cost Funds
Look for index funds with expense ratios below 0.2% to maximize your returns over time.
5. Avoid Panic Selling
Perhaps the most important tip: don’t sell just because the market is down. That’s often the worst time to exit.
Real-World Example: The COVID-19 Market Crash
In March 2020, when COVID-19 sent markets into a tailspin, the S&P 500 dropped about 30% in just a few weeks. Many investors panicked and sold their index fund holdings, locking in substantial losses.
But those who held on saw their investments recover completely by August 2020, and investors who actually bought more during the dip saw even better returns. By the end of 2020, the S&P 500 was up about 16% for the year despite the crash.
This illustrates a crucial point: temporary paper losses in index funds only become permanent when you sell.
Final Thoughts: Balancing Risk and Reward
So, can you lose money in an index fund? Absolutely. But that doesn’t mean they’re bad investments—quite the contrary.
Most financial experts agree that the biggest financial risk for most people is not investing at all. While saving money is important, inflation steadily erodes the value of cash over time. An index fund that averages 7-10% returns over decades can help combat this erosion, even with periodic downturns.
As I’ve learned in my own investing journey, success with index funds typically comes down to three things:
- Starting with realistic expectations about potential gains AND losses
- Choosing appropriate funds based on your time horizon and risk tolerance
- Having the discipline to stay invested during market turbulence
Remember, investing always involves tradeoffs between risk and reward. Index funds don’t eliminate risk—they just provide a structured, diversified way to participate in markets that have historically rewarded patient, long-term investors.
If you’re considering index funds, take the time to research different options, understand their expense ratios, and ensure they align with your financial goals. And perhaps most importantly, be prepared for the inevitable ups and downs along the way.
Have you invested in index funds before? What has your experience been like? I’d love to hear your thoughts and questions in the comments!
FAQ About Index Fund Risks
Can an index fund go bankrupt?
An index fund itself is unlikely to go bankrupt, as it’s essentially a collection of many different companies. The fund company that manages it could theoretically fail, but securities in the fund are typically held separately from the company’s assets.
Are index funds safer than individual stocks?
Generally yes. Because index funds contain many different stocks, they’re less vulnerable to the problems of any single company. However, they’re still subject to broader market risks.
What’s the worst-case scenario for an index fund investment?
Historically, major U.S. stock indexes have experienced drops of 50%+ during severe recessions. While rare, this level of loss is possible, particularly in the short term.
Should I avoid index funds altogether because of the risk?
Probably not. Despite the potential for losses, index funds remain one of the most accessible and effective ways for average investors to build wealth over time. Just be sure to invest with a long-term perspective.
How can I tell if an index fund is too risky for me?
Consider factors like the volatility of the underlying index, whether the fund uses leverage, its expense ratio, and most importantly, whether you can tolerate potential short-term losses while pursuing long-term gains.