Unlike most mutual fund schemes, Index Funds don’t aim to beat the markets. Their primary goal is to match an index’s performance. They are passively managed, i.e. they replicate the index and keep only those stocks in portfolio, which are part of index they are tracking. Due to passive management, costs associated with index funds are much lower than those which are actively managed.
Now before you think that a fund which doesn’t even aim to beat the market is far worse than one which atleast intends to do so, I would like to tell you that –
Majority of actively managed funds in India, have failed to outperform the indices in last 5 years.
Most investors would have been better off investing in index funds in last 5 years.
Note – In developed markets like US, 70-80% of actively managed funds fail to beat the indices. But same cannot be said for Indian markets. This deviation is generally attributed to high growth rate and less mature nature of Indian markets.
We at Stable Investor often claim that we are Boring Investors. We do not like stocks that are too exciting or which have very high growth forecasts. We would rather prefer more stable, boring and predictable business stories. And due to passive nature of Index Funds, we can safely put them in category of boring investments.
The pie chart given below is a snapshot of author’s current portfolio allocation.
You might think that though the author is talking of advantages of index funds in this post, he himself has not put any money in index funds. Though this is true, rest assured that this allocation is set to change in favor of index funds in near future as and when author starts a new SIP in index funds.
Apart from having low cost structures, there are some other benefits of index investing too. For example –
- Index funds provide long term solidity. Individual investments fluctuate a great deal. But an index fund, made up of 30-50 major stocks, is tied to market performance. Their volatility is quite low over longer periods of time.
- Index funds are independent of fund manager’s competence, his longevity or his character or any changes in any one or all of these. It simply and without any emotions, tracks a mathematically calculated entity known as index (it is actually ideal for investors who would prefer taking market risk rather than a fund manager risk.)
- There is much lesser churning of portfolio which results in lower transaction costs.
- An index fund is not exposed to financial disasters (bankruptcies, corporate frauds) which hit individual stocks and in turn, the investments of thousands of investors.
When Google prepared for its IPO in 2004, company realised that a number of its employees were about to become millionaires. Therefore, the company brought in a series of financial experts to teach them to make smart investment choices. Stanford University’s Bill Sharpe, winner of the 1990 Nobel Prize in economics said, “Don’t try to beat the market.” Even he advised Google employees to park their money in index funds.
While it is certainly possible that one could make more money by individual stock picking, the fact of the matter is that it requires too much work and gives too much stress to an individual investor. It requires devoting countless hours to reading balance sheets and checking out specific companies. And when you realize that how small are your odds of continued success, even after putting in a lot of hard work, you seem to start preferring a product like index fund. And once you read more about investment theories, you will be convinced that it is really difficult to beat the market consistently. For those who are patient enough and are ready to play the boring game of index investing, a low cost, diversified portfolio of index funds will produce an acceptable result over the long term.
Someone has rightly said – If you can’t beat them, join them. 🙂 (And index funds do just that)
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