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Why you should start with an index fund?

by Money Puzzle   ·  May 28, 2021   ·  

Why you should start with an index fund?

by Money Puzzle   ·  May 28, 2021   ·  

Photo by Allan Mas from Pexels

Investing is an important part of growing up and becoming an adult. It’s the one tick mark, the sooner you make it, the better it is for you. However, starting your investing journey into market-linked securities like shares and mutual funds is a daunting task, whatever your age might be. I know that even 40-year-old accomplished professionals, successful in their careers, struggle with starting out equity investing through market-linked securities like shares and mutual funds.

Their struggle is on two levels. Firstly, starting late is harder than one thinks, because you have to overcome years of reluctance and lethargy to handle risk in investing. Secondly, the issue is where to invest? For young earners, the first issue is nonexistent, you don’t have the baggage of complacency that years of fixed deposit and provident fund investing can bring in. You already understand that risk means you may lose capital. Hence, your choices are going to be more informed and there is nothing in the past that can pull you back.

However, the where to invest question is harder to resolve when you are younger. Without adequate experience, you may be easily taken in by the multiplicity of choice that presents itself. There are some 400 odd equity mutual funds to choose from, or you could pick from some 6000 odd stocks that are listed, or there are Smallcase portfolios too going into a few hundreds.

Choice is good in itself, but no one said that choice is easy to navigate.

Here is where a simple start can help solidify the foundation of your investing journey without the dilemma of excess choice. What is this simple start? It is called an index fund.

Before I get into what an index fund is and why it is the most appropriate choice to make, let’s first re-establish why starting your investing journey with equity-linked assets is important.

Why equity?

Do you all want to grow your money? Growing wealth or money means using what you have and investing it in a way that increases its value or delivers you compounded return. There are two components to this, firstly the actual return you make and secondly, leaving the investment to compound. The second part is more driven by behaviour, the appropriate behaviour requires you to let your equity investment remain untouched for a period of 7-10 years. If you have made diligent choices and picked good quality assets, there is a high probability of making your expected return.

Now let’s go back to part one, which is the more important reason to choose equity.

The net returns from your non-equity investments like bonds and fixed deposits are rarely going to beat annual inflation on a post-tax basis.

Inflation can eat your money if you aren’t diligent.

There are exceptions like the provident fund schemes, but investing in those is also with limits and let’s understand that those schemes are Government controlled where the interest rates can be lowered. In fact, over the last two decades, interest rates on these schemes have been consistently lowered.

Historical data and experience show us that investing in equity is one of the few flexible and certain long-term solutions to beating inflation and growing money successfully. At an expected long term average return of 12%-15%, depending on the amount of risk you are willing to undertake, you can not only beat inflation but also compound your money well.

The earlier you start this journey of compounding the more you will gain.

What is an index fund?

Now that we have established that equity investing is key to your early investment start, let’s understand why index funds make for the simplest choice to start with.

As we mentioned earlier, there are several funds and share you can choose from to begin investing in equity.

Investing directly in shares is a hard task because you need to understand the business and financial fundamentals of a company before starting and then figure out whether the market price reflects those fundamentals to point or not enough or too much. This in itself is a time consuming and technical task to undertake.

You’d rather utilize that time and brainpower in contributing to your professional career rather than your investment portfolio.

This is where managed funds like mutual funds fit in.

Here you invest in a scheme that is an already set portfolio of stocks. There are several types of mutual fund schemes available in largely two categories, active and passive. The Indian equity mutual fund industry is dominated by actively managed schemes where an individual(s) fund manager selects stocks for the portfolio. Index funds on the other hand are passive funds, a minority in the scheme of things, yet a smart choice for first-time investors. These schemes are not managed by a chosen fund manager, rather mirror the portfolio of a market index like Nifty 50 or Sensex 30.

A market index is a representative portfolio of stocks and there are several indices out there. The index portfolio is built based on certain quantitative rules, mostly around the market capitalization or size of a company’s equity value. At a bare minimum, by choosing an index you wish to invest in you will know whether you are investing in the large companies that operate in the economy or the mid-sized companies or the small companies.

Index funds, simply mimic the portfolio of existing market indices and give you an option to make a simple choice. If you were to go the active fund route, you will have to make several choices, starting with which fund manager, what kind of investment styles, which fund house and so on.

On the other hand, index funds from different fund houses or asset management companies are all the same as long as they are based on the same underlying index. Moreover, because there is no fund manager to make choices, there are no fees for the fund manager, the costs attached to an index fund are lower.

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