Lately, I got a bit more involved in the gamut of investing. Though it was fun reading the financial statements, going through companies’ fundamentals, financial metrics and optimism/pessimism of the market etc, but with the full-time job and family, this was too overwhelming. In this post, I want to discuss the index funds from a different perspective — passive investments and their impact on life quality.
Actively managing the equity portfolio can be quite intensive which requires one to deal with cumbersome process of stock analysis. Talking about what is the benefit of this process: trying to beat the market index i.e. generate alpha. If the market index gives 12% CAGR over 5 years and if you generate 13% CAGR, your alpha is 1%. Let me highlight how difficult is to generate this alpha. More than 50% of the mutual funds can not generate alpha and this number is only going to increase with RBI and SEBI making the market more structured. These are the trained folks (fund managers, analysts etc.) who are highly-skilled in stock selection and are in this game since long. It is their full-time job, still they fail to generate alpha consistently over the period of time. If that is the case, imagine what is there of us as free-time hobbyist stock pickers. On the other hand, what is guaranteed to perform modestly well is the market itself overall. The thing that these guys are trying to beat is the index, and if it is turning out to be quite strong, why not to leverage that. Index funds have proven to be effective across the world market. Below are some characteristics:
- Natural diversification: Index funds are made of several stocks that make the index. Hence, multiple high/medium/low quality firms give a good diversification.
- Low-cost: They are dirt cheap compared to other actively managed firms. HDFC Index Fund Sensex has expense ratio (ER) of 0.30% compared to HDFC Equity Fund which has ER of 2.11%.
- Lump-sum effective: Folks who have good understanding of gauging what is over-valued and under-valued, can take a good advantage of putting more money as lump-sum to these funds at right levels.
- Proven track-record: Just look at the performance numbers. They do not fall behind the actively managed funds, if not outperform them.
As you know, at Humbly Rich, we talk about Financial Independence and potential Early Retirement. The whole point is to come out of the rat-race and appreciate life. Actively managing your portfolio for that difficult alpha sounds like entering into yet another rat-race. Of course, if you really like stock picking, I would suggest give it a shot at a small scale. For example, allocate your 70-80% of portfolio to (various types of) Index funds and manage your active portfolio with the 20-30% amount. See over a decent 5-8 years if you are really getting the value in terms of alpha and happiness. If it does pay off, feel free to move your index fund portfolio to your portfolio. This test is necessary, because learning the hard way that you can not generate alpha is not a nice feeling and most importantly, as Mohnish Pabrai says “It is very difficult to make up of the lost compounding years”. So at this moment, let large (or entire) portion of equity portfolio compound with the Index funds and enjoy life!
Now with savings of huge number of hours per week from passive investing, you can really do something that you enjoy. Catch up with exercising routine, cook/eat nice food, talk to yourself, introspect with books, spend and create moments with family and friends. If you do not have hobby, start developing one. That is the biggest asset you will cherish during the retirement!