It is impossible to predict with utmost certainty how the markets will behave. Yes, you may find investment managers who manage to beat the market for a couple of years but in the long run, there is hardly any evidence of a manager whose portfolio has consistently delivered good returns over the decades of investing.
The closest one can ever come to generating decent returns over a long period of time is by choosing an investment strategy known as index investing. It is a passive approach where you buy and hold for a long period. This plan of action remains to be quite popular for a simple reason – it works!
In case you aren’t familiar with index investing, it is an investment approach which attempts to replicate the performance of stock market indices. The idea here is to generate similar returns as a stock market index. For instance, if BSE SENSEX goes up by 1,500 points over the course of one year, then your index investment plan based on this particular index should have exactly the same composition and also generate similar returns. To get more familiar with stock market indices, you can visit Bankbazaar.
The best way to take advantage of index investing is with the help of index funds. Index funds are just like mutual funds – they are a collection of bonds, stocks, et cetera. But instead of attempting to outperform the markets with meticulously planned strategies and active management, index funds simply attempt to mimic a given stock market index.
This is why index funds are often considered to be polar opposites of mutual funds. Mutual funds have fund managers who work actively to professionally manage the portfolio on behalf of the individual investors. These managers try to chase performance and select stocks which can outperform its peers in the long run. On the other hand, index funds don’t need this kind of management. By tracking a broad stock market index, index funds are essentially managing themselves.
This brings us to the first advantage of index investing – it is less expensive and time-consuming. It is much easier to replicate an index than attempting to pick a few stocks with high potential. The latter approach needs a lot of effort and time. Or in simpler terms, it is pretty difficult to actively manage your portfolio as you have to constantly track the performance of the companies, just like thousands of other like-minded investors.
Furthermore, if you are dealing with regular mutual funds, you will have to deal with high expense ratios and management fees. On the other hand, index funds need little governance and consequently, the management fees are fairly modest. This, in the long run, translates to better returns than the ones obtained from actively managed funds.
Another significant advantage of index investing is that this approach is highly diversified. It means that instead of investing your money in only one company, you are splitting your money and investing it in different companies. This, in turn, reduces the risk of losing your money. Diversification is one of the most important factors to consider while investing – whether it is active or passive.
Since index funds mimic the performance of stock market indices, their composition is similar to that of the indices. As a result, they provide the risk mitigation that an investor always seeks. For example, a NIFTY 50 index fund will have the same companies as the NIFTY 50 index. Therefore, by investing in this index fund, you are essentially investing in 50 different companies – a great way to mitigate risk!
Index investing also provides the consistency that an investor always looks for. Unlike a mutual fund, where the fund manager may decide to change the portfolio depending on the performance of the market, there is not much to change in the case of index funds. They are essentially tracking different markets and altering their composition will defeat the entire purpose of replicating an index.
Index investing is certainly an interesting strategy, although it is strongly recommended that you do your own research before following this plan.