Stock investing strategy- Index investing

by J Victor on September 27th, 2011

INDEX INVESTING

You know what a stock index is. Sensex, Nifty etc are stock indices. Index investing is all about having the same combination of shares in the same ratio as the target index so that it replicates the index itself. A change in holdings happens only when a company enters or leaves the index.

The biggest attraction of this strategy is that it is a humble approach.  Thousands of companies are listed in the stock exchange. If you were to start analysing the fundamental aspects of each and every company or even a selected group of companies, it would be a daunting task. Quite difficult even for experienced investors.  Research and analysis takes a lot of time and hard work. In such a scenario, Index investing works as a much easier way to invest in stocks. It provides the opportunity to invest in a diversified portfolio which would give you some decent returns. This strategy will not beat the market returns, but makes sure that you do get at least the returns offered by the market. It’s essentially a passive form of investing.

WHAT’S THE ADVANTAGE?

A stock, to be included in the index has to pass through various quality filters set by the securities exchange board. So when you invest in an index, the quality of stocks is almost assured. Your money goes into investing in some of the largest companies in the economy.

The liquidity factor is high. All segments of investors trade in the index in cash or in the derivatives segment and hence there is no lack of liquidity.

And, of course, you need worry about the timing of your entry. It’s easy to track an index. All you need to know is about the macro economic factors and enter when the index has hit a reasonable low.

However, there are some negative sides also. For example, the best performing stock may not the one that’s included in the index. So you miss the opportunity of not investing in a high performance company. When you compute the opportunity cost, it might be on the higher side.

A second disadvantage is that, within the index, certain large corporations dominate. A group of 3 or 4 companies may have a combined weight of more than 40% of the index. For example ITC, Reliance, Infosys, HDFC and ICICI bank constitute approximately 40% of the Sensex. So, if these 5 companies don’t perform, the index strategy will suffer.

WHERE TO START?

You need not make long list of stocks that are included in the index, find out the percentage of weight and then invest your money in the same ratio of the index which you are going to follow. That’s not the idea behind index investing.

Index investing works in a different way. It works through the mutual funds route. There are many index mutual funds in the market and one can subscribe to any one of them to follow this strategy.

For example The Franklin India NSE Nifty tracks and invests in the nifty stocks,   the Kotak Sensex ETF tracks the Sensex stocks. There are many more index funds in the market. The combination of stocks in the index decides where the fund would be invested by the fund manager and hence the index fund manager’s job is only to adjust the funds according to changes in the Index. The NAV (Net asset value) of a well managed Index scheme should be directly proportional to the index they follow. If not, it means that there is some sort of tracking or fund managing errors.

So, if you do not have the time or patience to analyse stocks but want to participate in the growth of the markets, index investing is for you. You are assured of approximately the same returns of an index.

You may like these posts: