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Index investing simplified:
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First some basics,
An index is a method to track the performance of a group of assets in a standardized way.
Eg: Nifty 50 tracks the performance of the top 50 Indian stocks.
whereas
An index fund is a fund that seeks to replicate the returns of an index.
An index is a method to track the performance of a group of assets in a standardized way.
Eg: Nifty 50 tracks the performance of the top 50 Indian stocks.
whereas
An index fund is a fund that seeks to replicate the returns of an index.
How does an index work?
An index owns all the stocks in an economy in *proportion* to their *market values*
Meaning the higher the market value of a stock, the higher the *weightage* in the index.
But there is a problem with this.
An index owns all the stocks in an economy in *proportion* to their *market values*
Meaning the higher the market value of a stock, the higher the *weightage* in the index.
But there is a problem with this.
You see, not all shares are *readily available*
Some are locked in the hands of promoters, strategic investors, etc.,
So to make an index *truly investible* it owns all the stocks in proportion to their *free float* market values.
Free float = Readily available shares.
Some are locked in the hands of promoters, strategic investors, etc.,
So to make an index *truly investible* it owns all the stocks in proportion to their *free float* market values.
Free float = Readily available shares.
Why index?
1. Discipline:
You lack discipline, fund managers lack discipline. The index doesn't.
It simply follows certain rules. It has no emotions.
"The fault dear investor is not in our stars, not in our stocks, but in ourselves"
- Benjamin Graham
1. Discipline:
You lack discipline, fund managers lack discipline. The index doesn't.
It simply follows certain rules. It has no emotions.
"The fault dear investor is not in our stars, not in our stocks, but in ourselves"
- Benjamin Graham
2. Expenses:
An active fund costs range between 1%-2.5%. While you can get an index fund for as low as 0.1%-0.2%.
A 1% fee reduces your final portfolio by *31%* over 40 years. In other words, your portfolio reduces by *almost one third*
An active fund costs range between 1%-2.5%. While you can get an index fund for as low as 0.1%-0.2%.
A 1% fee reduces your final portfolio by *31%* over 40 years. In other words, your portfolio reduces by *almost one third*
3. Outperformance:
Beating an index is a zero-sum game in the long run.
Over 70% of large-cap funds failed to beat the index in a 10 year period.
Beating an index is a zero-sum game in the long run.
Over 70% of large-cap funds failed to beat the index in a 10 year period.
4. Staying fully invested:
If you had missed the 10 best days of the S&P 500, your CAGR return would have been reduced by *almost a half*
Index don't time the market. The index is the market.
If you had missed the 10 best days of the S&P 500, your CAGR return would have been reduced by *almost a half*
Index don't time the market. The index is the market.
5. Simplicity:
The index is plain simple. You own a piece of all top stocks in an economy.
You don't need to read fund documents, hear fund manager interviews, try to find the next best fund.
The index is plain simple. You own a piece of all top stocks in an economy.
You don't need to read fund documents, hear fund manager interviews, try to find the next best fund.
Now, coming to risks,
1. Concentration:
Indian indices are heavily concentrated on a few stocks and sectors.
For instance, the top 10 stocks form around 60%, and the top 3 sectors form around 66% of Nifty 50.
1. Concentration:
Indian indices are heavily concentrated on a few stocks and sectors.
For instance, the top 10 stocks form around 60%, and the top 3 sectors form around 66% of Nifty 50.
2. Lack of control:
An index is a *set portfolio* meaning you can't choose the underlying stocks and their weights.
3. Zero downside protection:
If an index falls by 10%, your portfolio falls by 10% too as there is no fund manager to manage risks.
An index is a *set portfolio* meaning you can't choose the underlying stocks and their weights.
3. Zero downside protection:
If an index falls by 10%, your portfolio falls by 10% too as there is no fund manager to manage risks.
4. Lack of growth:
An index follows the *profits growth* of underlying stocks over the long run.
So, an index may remain sideways or even fall when the growth is low or zero.
An index follows the *profits growth* of underlying stocks over the long run.
So, an index may remain sideways or even fall when the growth is low or zero.
How to pick an index fund?
Pick a fund with
1. High AUM (Assets under management)
2. Low expense ratio (Fund expenses measured as a % of AUM)
3. Low tracking error (The difference between fund returns and index returns)
Pick a fund with
1. High AUM (Assets under management)
2. Low expense ratio (Fund expenses measured as a % of AUM)
3. Low tracking error (The difference between fund returns and index returns)
Which index to chose from?
The recommended combination is Nifty 50 + Nifty next 50.
Why?
1. They represent around 80% of the free-float market value of the Indian stock market.
2. All other index variants have either low AUM or high expenses or both.
The recommended combination is Nifty 50 + Nifty next 50.
Why?
1. They represent around 80% of the free-float market value of the Indian stock market.
2. All other index variants have either low AUM or high expenses or both.
Let's conclude by quoting John Bogle words:
"The winning formula for success in investing is owning the entire stock market through an index fund, and then doing nothing. Just stay the course"
Thank you for reading. Take care.
"The winning formula for success in investing is owning the entire stock market through an index fund, and then doing nothing. Just stay the course"
Thank you for reading. Take care.
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