Everyone wants returns. Whether it be a budding investor or a veteran, everyone would like to enjoy the contentment of knowing that they’ve ‘hacked’ the market, regardless of the amount they would’ve generated through whatever elaborate scheme they pulled off.
However, what goes hand in hand with earning returns, is risk; that stain you just can’t seem to scrub away from that shirt you love no matter what exquisite detergents you use. Depending on your appetite you can classify yourself as a risk taker or risk adverse.
Just to provide a little premise before dwelling into the topic at hand, risks are mainly divided into two broad categories: 1) Idiosyncratic Risks 2) Market Risks
Idiosyncratic Risks are risks that mostly relate to a particular firm. Suppose you own a share of Dell, the management may take different decisions that could invariably affect the future of the company. For e.g.: a development of a new operating system can come with a multitude of problems like what the competition is doing, would it be perceived as a success or a failure by the market etc. Market Risks are risks that relate towards the macro environment as a whole. These risks affect the economy as a whole or other certain broad subset cannot really be controlled. Situations like a recession during an economic cycle can bring down the stock price because of a slowdown in growth which would also result in other enterprises also facing declining growth and revenue.
Investors like you and me can mitigate these risks by investing in a wide variety of instruments across various asset classes; this act is called diversification. The most simple and common way of doing this is by dividing one’s available corpus through investment across debt instruments and equity instruments. The psyche behind this is that debt instruments provide fixed source of income through interest payments and will not be hampered by any fluctuations in the stock market. This acts as a deterrent to any loss being made in the equity market.
Ideally, an investor should invest in a wide variety of asset classes. This is where index investing comes into play. In finance terms, an index is a weighted average indicative sample of the market.
Index Investing is using a collection of different firms with an average being drawn out by the returns being generated by these firms. An analogy to help understand this could be the Consumer Price Index popularly referred to as CPI. It is used as a way to determine how well a country’s economy is doing by using an average of a basket of goods and services that a typical consumer would use. Changes in the prices of this would let economists know if prices have increased or decreased.
Diversifying one’s portfolio is not clear-cut way of eliminating risk, but it largely minimizes firm related risk, industry related risk and even country related risk. The only risk that one is susceptible to is systematic risk which is inherit when trading in the market. That is why is diversifying is such an important strategy and is commonly referred to as “the only free lunch” in corporate finance terms.
Investing into an index comprises of investing into a portfolio that is spread across a variety of companies; ranging from technology like Dell to something automotive based like Eicher Motors. It’s creating a sort of fail-safe plan, should one sector do badly it would be compensated by the performance of the other sectors.
Strictly, you would be earning the market returns which is referred to as Beta. The returns are quite substantial over a period of time. Suppose if you were to invest Rs. 100 in the Sensex which is the BSE’s index that comprises of 30 established and well – reputed companies on the 1st of April 1979, you currently would be holding Rs. 36,940 (24/9/2020); This is a multi-fold increase.
So, for all of those with limited capital, limited financial knowledge and operating in a supposed “efficient market”, index investing is steadfast and assured way of generating returns. Index Investing acts as a proxy for Indian Stock Markets. Index Investing not only helps at diversification, but it’s low cost through various SIP options and also easy to track by just looking at the points with your typical google search or heading of your favorite finance-based newspaper. It is transparent and helps provide security to newbie investors.
This is typically considered a passive form of investment, and in aggregate generate more returns as your typical investment in a stock due to the fees involved; it is easier to track therefore minimizes any form of error in prediction.
Index Funds have simply outperformed other schemes like Mutual funds not only through its generation of returns by its simplicity to understand as compared to other schemes that still requires a certain amount of knowledge to genuinely track it and understand the different jargons associated with that particular investment scheme. The only drawback is during an economy cycle downturn, it may underperform as compared to actively managed funds, but the returns of other companies not very affected could bring it back to par.
Another popular option that is open to investment that imitates the stock market index is NSE Nifty that represents the weighted average of the 50 largest Indian companies listed on the NSE.
Investors typically looking for a safe and predictable returns should look in investing in Index Based Funds. Investment is normally done for a long-term horizon with fluctuations being experienced in the short term, but it averaging out in the long term of maybe 5 years and <; Transaction costs are way lower, because investment is mainly held for a period of time as compared to actively managed funds with a large number of transactions.
Written by Rohann