For risk-averse people, who cannot actively manage their investments in the stock market, this could be the perfect solution  

Not everyone is adept at investing actively in share markets due to the unpredictability of stock prices. Putting money in the stock market requires professional expertise which most common people lack, making them wary of the bourses that can be quite volatile. For such investors and for beginners, who wish to put money in the stock market but at the same time cannot actively manage their investments properly index investing could be the perfect solution.

Index investing is a passive investment strategy that attempts to generate similar returns as a broad market index like the Bombay Stock Exchange Sensex or Nifty 50 by replicating its performance. This can be achieved by investing in mutual funds that closely tracks the underlying index, which could be either an equity or fixed-income index, and trying to replicate its performance. When an index fund tracks a benchmark like the Nifty, its portfolio will have the 50 stocks that comprise Nifty in the same proportions.

Proponents of index investing, supported by modern financial theory, believe that it is impossible to beat the market as  trading costs and taxes eat into any high returns generated by active portfolio management. Empirical research finds that index investing tends to outperform active management over a long time frame. Adopting a hands-off approach to investing eliminates many of the biases and uncertainties that arise in a stock picking strategy.

A 2013 study by Ferri and Benke actually showed that index investing outperformed similar active strategies more than 80 per cent of the time. That is, in the vast majority of cases, simply taking the market returns produced better results than trying to beat it. Since index investing takes a passive approach, index funds usually have lower management fee and expense ratios than actively managed funds, making it an effective strategy to manage risk and gain consistent returns.

The simplicity of tracking the market without a portfolio manager allows providers to maintain modest fee. Index funds also tend to be more tax efficient than active funds because they make less frequent trades. There are several advantages of index investing.

Low costs: One of the biggest reasons that index investing is so effective is also one of the simplest and that is its low-cost. Price is actually the single best predictor of a mutual fund’s future performance. Better than past returns. Better than the fund manager’s track record. Low costs lead to better returns. Index funds are often the most economical investments available simply because they don’t require a portfolio manager who needs to be paid. And they also don’t incur all the trading costs, taxes and other expenses that go into some of the more active strategies. Index funds have a simple job and that is to track the market. That simplicity keeps them affordable and these low costs are then passed on to investors in the form of higher returns.

Diversification matters: Index funds are diversified. For example, instead of buying just a few stocks, you can spread wings by buying stock in every single company in India. By doing so, you’ve removed the risk of any single company sinking your investment portfolio. Because index funds invest in entire markets, they are a great way to get the diversification you’re looking for.

Consistency is the key: Sticking to one’s investment plan is one of the five most important things one can do as an investor. As the markets move up and down, there will always be people around you, consumed with either fear or greed. But buying and selling based on those emotions typically doesn’t end well. Instead, best investors stick to their plan, no matter what is going on around them.

However, despite gaining immense popularity in recent years, there are some limitations to index investing. Many index funds are formed on a market capitalisation basis, meaning the top holdings have an outsized weight on broad market movements. If ICICI Bank or Hero MotoCorp, for instance, experience a weak quarter, it would have a noticeable impact on the entire index. For putting money in index funds, investors should find index funds that are able to mirror the performance of the underlying index and stay away if the fund’s performance lags the index by much more than the expense ratio.

On the whole, index funds are excellent alternatives to active investing, particularly on a long-term basis, because of their ease of use, instant diversity and higher returns. Risk averse investors and beginners can choose this route to invest in stock markets relatively safely and enjoy the advantage that they bring.

(The writer is Assistant Professor, Amity University)