Warren Buffet, one of the world’s most successful investors, said that for most people, index funds are the best way to invest in the long term. But why is this the case? He said,
“In my view, for most people, the best thing to do is own the S&P 500 index fund. The trick is not to pick the right company. The trick is to essentially buy all the big companies through the S&P 500 and to do it consistently and to do it in a very, very low-cost way.”
Let’s explore what index mutual funds are, how they work, their benefits, how they differ from actively managed mutual funds and how you can get started with stocks in stock market passively.
Index Funds are the best way to enter long-term investing. Start investing now.
What Are Index Mutual Funds?
An index fund is a type of mutual fund with a portfolio made to match or track the components of a financial market index, such as the NIFTY 50, BSE Sensex and S&P 500. Their main goal is to simplify investing.
In short, they are passively managed mutual funds. Hence, known as index mutual funds.
What Are The Benefits Of Investing In Index Funds?
As per the Association of Mutual Funds of India (AMFI), they create a portfolio that mirrors a market index. Here are the benefits that index funds have:
1/ Firstly, the securities included in the portfolio and their weights are the same as those in the index. You, as an investor know the stocks that will form part of the portfolio since you know the composition of the index.
2/ Secondly, the fund manager does not rebalance the portfolio based on their view of the market or sector. So, the performance of index mutual funds do not depend on biasness.
3/ They are passively managed, which means that the fund manager makes only minor, periodic changes to keep the fund in line with its index. Hence, index fund offers the same return and risk represented by the index it tracks.
4/ All the fees that an index fund can charge are capped at 1.5% as per AMFI.
How Do Index Funds Work?
When you invest in an index fund, you are putting your money into a basket of stocks or bonds that represents an index. The fund’s performance is then directly tied to the performance of that index.
For example, you invest in a NIFTY 500 index fund. NIFTY 500 index includes 500 of the largest listed companies in India, representing more than 95% of the full market capitalisation of the National Stock Exchange (NSE) of India. So, you are essentially buying a piece of the top 500 companies in India, as tracked by the index.
What Is The Difference Between Index Funds And Mutual Funds?
Here are the differences between Index Funds and Mutual Funds that you must know before investing:
1/ Type Of Management: Mutual funds are actively managed, meaning fund managers make decisions about buying and selling stocks within the fund’s portfolio. They do this to outperform the market. On the other hand, index funds are passively managed. They simply replicate the index, meaning less frequent trading and better performance due to lower management fees and consistent returns.
2/ Cost-Effectiveness: Index funds usually have lower expense ratios because they don’t require the active management of mutual funds. While a mutual fund might charge higher fees as active management charges, index funds cannot charge beyond 1.5% as per the Association Mutual Funds of India (AMFI).
3/ Performance: As per the SPIVA report, passively managed funds have consistently beaten actively managed funds across multiple time periods.
Why Invest In Index Funds?
Index Funds can be the base of your investment journey. Let’s talk about the reasons why you should invest in them:
1/ Simplicity: Index mutual funds have an easy approach to investing. You don’t need to analyse the shares in market or worry about timing the stock market.
2/ Diversification: By investing in an index fund, you gain exposure to a wide range of stocks, which helps manage risk.
3/ Low Costs: The low transaction costs and management fees simply mean more of your money stays invested in your chosen funds.
4/ Performance: Over time, they have consistently provided solid returns, making them an excellent choice for long-term wealth building.
How Should I Invest In Index Mutual Funds?
Here are the steps you can follow:
1/ Choose Your Index: You must decide which index you want to track as per your risk profile. Such indices include the Nifty 50, BSE Sensex or international indices like the S&P 500.
2/ Select A Fund: Now, you choose an index fund that tracks your chosen index. You could compare funds based on expense ratio, tracking error and performance history.
Note: Past performance cannot be the only indicator to assess future performance of a particular fund.
3/ Set Up An Investment Account: While a Demat account is not necessary for mutual funds, having one might be beneficial if you also want to invest in Exchange Traded Funds (ETFs), which are traded like stocks.
4/ Start Investing: You can invest a lump sum amount or start a Systematic Investment Plan (SIP) to invest regular amounts.
What Is A Tracking Error In Index Mutual Funds?
A tracking error measures how closely an index fund follows its benchmark index. Lower tracking errors mean the fund is more accurately mirroring the index performance.
Can I Lose Money In An Index Fund?
Yes, like any investment, index funds carry risk, primarily the risk of market fluctuation. However, they are considered to have lower risk compared to picking individual stocks.
How Much Should I Invest In Index Funds?
You can start with an amount you are comfortable with and can afford to invest long-term. Even small, regular investments can grow significantly by the power of compounding.
Want to plan your SIPs according to your goals and specific risk profile? Here’s an SIP Calculator for you.
Index funds are an excellent way for beginner investors to get into the world of investing. They are simple, cost-effective and offer a way to invest in the broader market with less risk. By understanding your goals and risk profiles, you can start your investment journey easily and grow your wealth over time.
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