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Daily Roundup: Index investing 101
Index investing: Only way to guarantee fair returns for everyone
Investing is not easy. Few people have the time, energy, knowledge, temperament and skill to pick stocks that would create wealth for them over a long duration.
If you were to estimate how many of the top 20 global companies (by market cap) today were also in the top 20 list 30 years ago, what would your guess be?
The answer - none. Now consider the difficulty of predicting what the list will look like 30 years from now and which company is going to be the next Amazon or Google. How many people had even heard of Amazon 25 years ago?
Turning to investment professionals won’t help either. Roughly 80% of all equity funds that have existed since 1970 in the US have gone out of business and more than 97% would have been out-performed by any low-cost broad-based index fund.
So you have an entire profession that is being paid for accomplishing basically nothing.
So what should people do?
History has shown us and the math confirms that the winning strategy for investors is to own all of the country’s publicly held businesses at a very low cost through an index fund.
What are index funds?
“Don't look for the needle in the haystack. Just buy the haystack!" — John Bogle
‘Index funds’ — in their most basic form, are mutual funds or exchange-traded funds that buy shares of effectively all of the stocks in the country’s stock market and hold them forever.
As a whole, the overall returns of the stock market must be equal to the returns that all the investors get. And these returns are almost entirely driven by the dividend and earnings growth of corporations and not by speculative short-term activities by investors. Thus, investing in low-cost broad-based index funds is a stress-free way for the investors to get close to all the returns that the market generates.
“In the short run the stock market is a voting machine…in the long run it is a weighing machine.” - Ben Graham
There cannot be another Warren Buffett, but if you had started out at the same time as when he bought his first stock back in 1942 and had invested USD 10,000 in an Index Fund that re-invested dividends, your investment would be worth over USD 51 million today. You did not have to look at a single headline. All you had to believe in was that America was going to do well.
Similarly, if you believe that India is going to do well in the coming decades, owning the majority of the publicly owned businesses via Index Funds allows you to grow with India.
Why do investors in managed funds lag behind index investors?
High costs - Fund managers extract heavy costs for their services. Furthermore, they are involved in a lot of short term speculation and this frequent buying and selling of securities incur higher taxes and transaction costs.
Low priority to dividend income - Dividend reinvestments are the primary source of growth in the stock market over the long term. Fund expenses consume a huge share of the total dividend income earned by funds.
Bad timings and poor fund selection- People give their money to most funds after a good performance, and they take it out when bad performance follows. But performance comes and goes. As do the managers. Only 14% of five-star funds in 2004 still held that rating a decade later.
How to select and invest in index funds?
Select broad-based funds with the lowest expense ratios and turnover costs - Expense ratios (the management fees and operating costs of the fund) are the most dependable predictors of performance. The lower the better.
Invest with reputable fund organizations - Keep things simple. Go with organizations that have a reputation for being investor centric and that have higher assets under management.
Buy and hold - It's said Einstein called compound interest the eighth wonder of the world and in order to let it work its magic one must stay the course.
Potential risks with index investing in India
Lack of truly broad-based funds - In India, the index funds that are based on the Nifty and Sensex aren’t as broad-based and run the risk of over-representing certain sectors.
Lack of stricter regulations by SEBI - In May 2021 some of the Index Funds in India suddenly raised their expense ratios. Such behaviour in which funds lower expense ratios to attract investors and then raise them must be regulated.
Investing in index funds that track only certain market sectors - Though investing in specific market sectors is done most easily through index funds and ETFs, betting on one winning sector over others is still betting, which is not a winner’s game.
Investing is risky, but not investing is a surefire way to fail to secure a sound financial future. Index funds are still the best bet for most investors to end up with above-average returns.
“By periodically investing in an index fund, the know-nothing investors can actually outperform most investment professionals.” -Warren Buffett
“Building a portfolio around index funds isn’t really settling for the average. It’s just refusing to believe in magic.” -Bethany McLean of Fortune