April 16, 2010

Q&A from the previous post

The previous post on indexing generated a lot of comments and questions. I will list some of these questions and answer them from my perspective

Q1 – If you can beat the market, why do indexing?

This is one of the most common questions. The issue is not as black and white as it seems. Let me try to break my response into several points

Did you beat the market or were you lucky?

How do you know beforehand, that you 'will beat' the market? Let’s say you beat the market for 3 yrs. how do you know its luck or skill? Most of us think its skill!!

The only way to know that, is to keep doing it for 6-7 yrs and see how it plays out. One can be convinced then and put more eggs in the active investing basket, but till that happens what should one do?

Now if you follow this thought process, what is the best next best opportunity - i would say investing in mutual or index funds.

I have invested a part of my capital in the past in stocks directly as i did not want to risk the whole money. If you think that is being too chicken, I thought so too. I started by investing 100% directly, saw my portfolio go down by 20% and learnt my lesson. So unless one is sure that one has the skill to beat the market and has the data to back it up, one should be careful about going 100% in stocks.

Amount of time available
Do you have the time to learn and track all your stocks on a regular basis? It is amazing that so many investors, if you can call them that, think that beating the market is child’s play. One has to spend 1-2 hrs per week, watch CNBC and pick a stock tip here and there and that’s it.
Is there is any activity in life which will reward you with good monetary returns easy ? If it was so easy, why are there so few full time investors ?

So if you are working full time and do not have the time and interest in analyzing and researching stocks, the next best option is to invest via mutual funds and index funds

Q2 – Mutual funds are horrible, they charge 1-2% expense ratios. Even index funds are bad as they have high tracking errors

I have never understood this argument. I agree mutual funds in India are sneaky, bad and indulge in bad practices. So what is the alternative? Fixed deposits?.

The only way to participate in the equity markets is to buy stocks directly or via mutual funds. I would say 95% of investors should not invest directly. That may sound harsh, but it better than losing money and your shirt. The second best option is either mutual funds or index funds. There is no other option to invest in the equity market.

Real estate is a different story. But if you have Rs 20000 to invest, is real estate an option?

Please don’t even get me started on gold, oil etc. All this enthusiasm is due to the recent run up in gold price. Can you build a retirement plan around gold and other kinds of commodity investing?

Q3 – can you give some example of mutual funds ?

I have discussed some funds
here. Some funds I like are HDFC equity fund, Reliance growth fund and Franklin Templeton blue chip fund. I have invested mine and my family’s money in it.

Are these the best funds out there? I think not. They are good enough and work for me.

For index fund, Nifty BEES (exchange traded funds) offer the lowest cost and tracking error. However they trade like stocks and so one cannot setup an SIP. As indexing is still not used widely, most index funds have high costs and hence a tracking error of 1% or more (tracking error is the difference between the index and the fund’s returns).

So if you want to do an SIP, pick either a decent mutual fund or one of the index funds with the lowest tracking error and set it up. It is better than having these intellectual arguments about the 1% difference and not do anything about it.

Sometimes it is better to go for a 90% solution than trying to achieve perfection.

Additional thoughts
I have seen a lot of different approaches to indexing. Buy when the PE falls below 12 or rises above 20 or when dividend yield is below this or that – wait I have
written that myself :)

If you are generally interested about investing and like to play around or spend time on it like me, try all the gymnastics. However at the end, if you analyze the results you will realize that all you got out of it was a minor 1-2% annual advantage.

I think it is much smarter to pick a decent index fund or mutual fund, set an SIP and get on with it. Check the performance after every 1-2 yrs and you will find that you are doing fine.

Of course no one is likely to accept this suggestion as it does not feel smart. Where is the fun in it ?


Vishleshak said...

I think FT india dynamic PE fund works like what you mentioned. They dont get into complete sell or buy mode but same philosophy. I think over a long term they beat sensex by around 5-6% if I remember correctly when I checked last. So those who are convinced should utilize this fund.

student said...

Hi Rohit,What is your opinion abt Junior Nifty ETF.I have some concern about its liquidity but other than that since the maximum growth is going to come from Midcaps and smallcaps , should I consider it?

karthik said...

Hi Rohit,

I had the same dilema last year. But I was pretty sure that I cant invest 100% in equity. So I wanted to split the investment into MF thro SIP (65%) ,ETF (30%) and direct investment (5%). MF was no problem but the Market was in a high so I felt Index was/is overvalued. So I started a RD which I plan to close once the market tanks.
I try to limit the direct investment to an amount which I can afford to lose. This is basically to learn and have some thrill :).
Any thoughts on this?

Anonymous said...

Well written post...throws light into the world of investing and wealth creation for prospective investors!