For investors who are looking at entering the stock markets today, investing in index funds makes more sense. Here's why.
“Be fearful when others are greedy and be greedy when others are fearful” – can be explained in today’s market conditions well. Equity flows have slowed down dramatically on the back of weak performance, especially over the last few months.
As most investors become cautious and start allocating more of their money in safe assets, smart investors are doing the opposite. When the media was talking about the Great Depression scenario in 2009, most investors stayed out of the markets. Two investors, however, were pouring billions into the economy. One was Warren Buffett, and the other one was Howard Marks (founder, Oaktree Capital). As the whole world abandoned equity as an asset class – what made them do this?
# No fear of short-term – Both of them were sitting on long-term patient capital and were ready to lose more in the short-term. Short-term risk aversion is what leads to poor decisions for a lot of people.
# Experience – Both of them were also sitting on decades of experience. From experience, they learned that markets over the long-term tend to follow the intrinsic value of companies. Intrinsic values of most companies were at a lifetime low during the time. They were not timing the market – they were buying cheap.
With the ready availability of NAVs, real-time stock prices and thousands of investment products out there today – a lot of investors tend to switch mutual funds faster than stocks. Besides – today a lot of investors tend to see their performance every day (sometimes multiple times a day). For someone who enters the stock market with a 10-year plan – checking daily NAVs makes little sense.
For investors who are looking at entering markets today, do index funds make more sense?
1. Index funds are great for first-timers – First-time mutual fund investors may not have the time or the skills to pick the right mutual funds. Selection becomes more complex in today’s uncertain environment. To save time and for simplicity – index funds make things easy for them. Instead of trying to pick the right mutual fund from thousands of options out there (without professional help) index funds make it economical and easy. Investors worried about poor performance may not – as returns of index funds are at par with the rest of the industry.
2. Minimalist approach – Minimalism stands for less is better. Most investors today tend to have a lot of mutual funds. This approach is very ineffective over long-term periods. A beginner should be happy with a few funds – including one broad-based index fund combined with an international index fund for diversification.
3. Asset allocation matters – Investors spend a lot of time trying to find the right fund for their portfolios. In reality, the percentage allocation matters a lot more than what the investor buys. Focus on asset allocation at the right risk profile, combined with disciplined investing. This approach leads to maximum effectiveness.
4. Index funds are suitable for most investors (not just entry-level). More sophisticated investors should allocate their core portfolios to index funds. This part of their portfolio is something that should not be touched for long-time periods. Index funds get more effective the longer an investor holds them.
In conclusion, this remains an excellent time for anyone looking to allocate long-term capital to equities. Predicting the future is impossible – and investors, as a result, should not fear near-term losses and invest in both bull and bear cycles for maximum portfolio growth. Index funds may be useful for simplicity purposes in today’s market conditions.
(By Pratik Oswal, Head of Passive Funds, Motilal Oswal Asset Management Company)
Disclaimer: This is the personal view of the author. Readers are advised to consult their financial advisor before making any investment.