Why is that?
It is because of the continuous risk that individual investors have to take. This risk could take many forms. Picking individual stocks carries the risk of making the wrong decision. Deciding the weights of stocks and sectors in a portfolio is another challenge. There is also the risk of having a market cap bias in the portfolio. The greater the tilt towards small caps, the higher the risk.
A portfolio intended to beat the market will have to take some kind of risk, which will have to be maintained over the long term. Even if all this is done well, there is still no guarantee that the portfolio will beat the benchmark. It’s no wonder that very few people manage to outperform the index over an entire investing career.
In fact, we’d go so far as to say that most investors who beat the index over the long term do so because of one or two stocks. Excluding the gains from these stocks means that the overall returns over a lifetime of investing may not be much better than the benchmark.
One huge multibagger is enough to change an investor’s financial fortunes. A 100-bag stock, if enough funds are committed to it, can ensure a comfortable retirement. The contribution of all other stocks to that investor’s portfolio would not be as important as the 100-bagger.
You don’t have to take our word for it. This is what Benjamin Graham, the father of value investing and guru of Warren Buffett, said back in 1976.
“In 1948, we made our Geico investment and from then on we seemed to be very brilliant people.”
This stock, Geico, more than any other, is responsible for its excellent investment performance.
He also said this…
“Ironically enough, the aggregate of profits obtained from this single investment decision far exceeded the sum of all others realized through 20 years of extensive operations in the specialized fields of the partners, involving much research, endless deliberation and countless individual decisions.
“Is there a moral to this story of value for the intelligent investor? The obvious thing is that there are several different ways to make and keep money on Wall Street. Another, not so obvious, is that one lucky break, or one most astute decision – whether can we distinguish them?—can account for more than a lifetime of traveling efforts.”
So, there you go. One big winner is all you need to beat the market in a big way. By ‘big gainer’ we mean a stock that multiplies the original investment more than 10 times, preferably 25 times or more. This is why so many investors are desperately looking for the next huge multibagger stock. But then why do so few investors beat the market in the long run?
Here are the reasons.
- Don’t find a multibagger stock over an entire investment carrier. Yes, this is possible. Some investors just don’t find one.
- Not recognizing multibagger. This is more common. Many investors have trading portfolios. They could end up trading a multibagger stock and even make a profit. But they don’t consider it a long-term investment.
- Not keeping the multibagger for more than a few years. These stocks must be held for at least 15 years or more to make a big difference to your financial life. Selling a life-changing multibagger stock prematurely is a big regret of many veteran investors.
The number of traders who consistently beat the market is even lower than the number of investors who do so. At least an investor can get lucky – ie, find a multibagger – and then simply hold it for a long time to beat the market.
This is not possible in business. There are no consistently lucky market traders in the world. Indeed, there are very few traders who consistently beat the market.
So, what to do?
The answer is simple. Don’t try to beat the market. Instead make sure you get your fair share of market returns. Investing in a low-cost index fund is the right way to do this.
Index funds in a nutshell
An index fund is a mutual fund that is passively managed – ie the fund manager actively picks any stocks. It just mimics an index, usually the benchmark index like the Nifty or Sensex. To do this, its portfolio is built and maintained in the same ratio as the index.
And that’s it. By investing in Nifty index fund, you will get returns very close to Nifty’s. This is the purpose of an index fund. It will ensure that you get your fair share of wealth created by the Indian stock market.
Best of all, their passive nature ensures that they are inexpensive. In India the total expense ratio for index funds is between 0.2% and 0.5%. For active funds, the TER is between 1% and 2%.
Are index funds better than other mutual funds?
In the short term, say one year, it is impossible to say that with any certainty. Again, you shouldn’t really be in the stock market if your investment horizon is one year. The market rewards patience as long as you have picked good stocks.
And this is where index funds shine. Over five years and 10 years, only a few actively managed mutual funds beat the benchmark.
Conclusion
Index funds are a good choice for long-term investors looking for solid returns without taking on excessive risk.
This does not mean that index funds are low-risk investments. They carry just as much risk as any other stock market investment. However, the types of risk associated with active investing, such as picking stocks, are absent in index funds.
Also, just because you like the idea of index funds doesn’t mean you shouldn’t do your due diligence. Do your research. Check the expense ratios. Check how close the performance of an index fund is to the index itself. Check if the fund manager deviates from the mandate of passive investing.
Happy investing!
Disclaimer: This article is for informational purposes only. It is not a stock recommendation and should not be treated as such.
This article is syndicated from Equitymaster.com