Investing is the best way to increase the worth of your money in the long run. It also helps one achieve their life’s short term and long term financial goals. Those who are focused on financial planning are more aware of the importance of investing more than anyone else. One of the best ways to grow your money and to improve your existing financial condition is by investing in market linked schemes like index funds.
Let us take a look at index funds and understand why they are a simple and easy way to enter the stock market.
What is an index fund?
An index fund is an open ended mutual fund scheme that follows a passive investing strategy. Mutual funds can be broadly categorized as active funds and passive funds. Active funds have the active participation of the fund manager who is responsible for actively managing the portfolio and trading its underlying securities regularly to benefit from the prevailing market conditions.
On the other hand, passive funds like index funds are designed in such a way that they try to generate capital appreciation by mimicking the performance of their underlying benchmark or index with minimal tracking error. They are different from ETFs, another passive mutual fund category that is listed on the stock exchange and whose units can be bought/sold just like company stocks.
How are index funds different from active mutual funds?
There are some similarities between index funds and other active funds. Like they pool financial resources from investors sharing a common investment objective and invest this sum in a pool of securities to generate capital appreciation. However, active funds may invest in companies listed on different indices, but index funds only invest in securities of companies belonging to one specific benchmark like NIFTY 50, SENSEX 30, etc. While active mutual funds try to outperform their benchmark, passive funds like index funds do not try to outperform but instead, their underlying securities just try to replicate the performance of their benchmark to generate returns.
Are index funds a good way to enter the stock market?
We all know that the equity market is highly volatile. It fluctuates constantly almost every day which is why equity scheme investors keep a long term investment horizon of a minimum of five years while investing in them. That’s because even if equity markets are risky, in the long run, they are known to deliver and allow investors to create wealth. Investing in index funds can be a good idea because they invest in a diversified portfolio of stocks. This allows the index fund portfolio to mitigate its overall investment risk and benefit from various stocks that have growth potential. So even if a few stocks underperform, other stocks in the portfolio may be able to generate risk adjusted returns. By investing in a single index fund, investors get exposure to various stocks. This is not possible when you invest directly in the stock market as investors need to purchase individual stocks and cannot invest in a basket of securities like index funds. Also, investing in direct equities paves the way to concentration risk which can be averted if one invests in index funds instead.
Also, investors start a SIP in index funds and invest small sums regularly instead of directly investing in the stock market where one single stock can cost thousands of rupees. Investors can also use the SIP calculator to compute the total estimated returns they can earn at the end of their investment journey. Having said that, index funds do not guarantee returns and hence investors should consult their financial advisor before investing.