In this article, we discuss the pros and cons of investing in index funds versus picking individual stocks.
Investing Strategies
Any investment strategy is linked to three factors associated with the investor: his or her risk appetite, knowledge of the companies and the time available to engage in making bets. It is not enough for one or two of these factors to decide on how to go about investing money.
One may have a lot of intrinsic knowledge of a company or a sector and also a risk appetite but not have the time to devote to actively make direct investments in a stock. That said, time element is relatively less important unless one is into trading. If one is looking to make a long-term investment in a stock one need not monitor it every few hours.
On the other hand, one may have time and risk appetite but not enough knowledge and many a times they burn their hands with an aggressive stance lacking information of a company.
Then again, one may have the knowledge and the time but not the stomach for riskier bets.
In all these cases where one or two of the three ingredients are missing, a passive investing strategy works best. In such scenarios, one is more likely to, and it is advisable to bet on an index fund.
This can be a sector-focused index fund or a broader market or a thematic index fund.
What is an index fund?
An index fund is a collection of a set of stocks falling within a particular sector, say a banking sector or IT sector and so on. It could also be one that mimics the benchmark stock market indices like a BSE 30 Sensex or a Nifty 50 and so on.
In short, investing in such funds is akin to investing in a set of company stocks of a particular theme, sector, or collection. By default, it diversifies the risk that otherwise comes from betting on a single company.
Such investments can be done typically via mutual funds but some are also traded on a daily basis like a stock, for instance Nifty Bees that tracks Nifty 50 stocks.
Top Index Funds
Here’s a list of the top 10 index funds on Kuvera, sorted by returns in the last 3 years. *Data as on 23 April 2024.
Remember, past performance is not an indicator of future returns.
| Top Index Funds on Kuvera by 3Y returns* | 3Y | TER |
| Motilal Oswal Nifty Smallcap 250 Index Growth Direct Plan | 30.06% | 0.36% |
| Nippon India Nifty Smallcap 250 Index Growth Direct Plan | 29.94% | 0.32% |
| Aditya Birla Sun Life Nifty Midcap 150 Index Growth Direct Plan | 27.81% | 0.44% |
| Motilal Oswal Nifty Midcap 150 Index Growth Direct Plan | 27.74% | 0.30% |
| Nippon India Nifty Midcap 150 Index Growth Direct Plan | 27.48% | 0.30% |
| UTI Nifty200 Momentum 30 Index Growth Direct Plan | 25.55% | 0.46% |
| Aditya Birla Sun Life Nifty Smallcap 50 Index Growth Direct Plan | 23.26% | 0.50% |
| Kotak Nifty Next 50 Index Growth Direct Plan | 23.06% | 0.34% |
| DSP Nifty Next 50 Index Growth Direct Plan | 22.96% | 0.30% |
| IDBI Nifty Next 50 Index Growth Direct Plan | 22.90% | 0.32% |
When is stock picking superior to index funds?
Individual stocks can generate multi-baggers in a jiffy, provided one gets the right stock at the right time, as yet undiscovered or set to undergo a dramatic twist in its fortunes. It is not uncommon for some big gainers to jump 10-20 times within a short period of 1-2 years.
This is because a beaten-down stock has suddenly found its mojo with a turnaround in business and thereby earnings, or has acquired a corporate heavyweight as a new strategic buyer, and so on.
Many stocks also move countercyclical to the broader market. While the broader market and benchmark indices may be hitting lows due to poor sentiments about the economy, some companies and their stocks may be beneficiaries due to reasons peculiar to them. Think of defence-related stocks at the time of war or drug counters at the time of a pandemic.
To be sure, while multi-baggers with superlative returns are a possibility with selective stock picks, those are not the norm. Such outperformance is shown by a very small proportion of stocks.
When are index funds a better call?
The biggest advantage of playing with an index fund is that it spreads the risk while taking advantage of outperformers in the basket of stocks. While one may not be able to fully benefit from, say, a big pharma company’s stock, having a part of the investment parked in a pharma index allows one to have exposure to those multi-baggers, too, albeit only partially.
Similarly, one may not be able to reliably choose the biggest gainer among the Nifty 50 stocks for the next three years, but if one invests in Nifty index fund then a part of the bet would be on that outperformer too.
As a result, index funds make for a safe way to get exposure to some of the best stocks. If one does not have time for daily monitoring of stocks then too such funds work better.
One takes a more calculated risk by hitting the buy button on a sectoral or thematic index fund as against one of the benchmark index funds.
Interested to invest in index funds? Start here.
Stocks or index funds?
The final decision on which one works better depends on the investor. For a conservative investor who is relatively risk averse, index funds are a better choice. This is regardless of whether they have good knowledge about individual companies and also have time to make quick calls every day, given the market realities.
If one does not have time or intrinsic knowledge about the companies, then it is better to go for index funds, provided one is convinced about the future growth of the economy. This is even more so if one is a long-term investor and is okay with short—to medium-term swings.
If the investor has a large risk appetite, does stock and company research full time, has a good knowledge of a company or a set of companies, and the time to devote to monitoring the stocks of interest, then they could try out individual stock picking. This is because such an investor has an opportunity to take advantage of the alpha they can generate by making smart bets on a beaten-down stock poised to shoot up again or by backing an as-yet-undiscovered gem.
Some investors also tend to get lured by few mutual funds that have done well in the recent past. Historical data, however, shows that a majority of such mutual funds tend to underperform the index funds.
So, while a passive index fund-anchored investment strategy may seem boring compared to the appeal of finding a hidden gem of a stock, for most investors, an index fund works better as a way to grow their wealth.
Moreover, how much risk can one bear is the most critical determinant of the investment strategy that works best.
Ready? Starting mutual fund investments is really quite simple on Kuvera.
Interested in how we think about the markets?
Read more: Zen And The Art Of Investing
Watch here: Understanding Index Funds | Expert Insights for Smart Investing
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