Thousands of people flock to the stock market every day with the intention of making capital gains. But if only it were that easy! Stocks are certainly one of the best investment avenues and can generate passive income for you. It can, however, be quite challenging to pick the right stock to invest in.
This is where index investing comes in. This method can help you grow your savings consistently over time.
How? Let’s find out! In this guide, we will demystify index investing, explore different types of market indices, explain how index investing works, and discuss its benefits and risks.
What is an Index?
There are over 2,000 companies listed on the NSE and over 5,000 on the BSE. It can be hard to go through the performance of all of these companies to figure out how the market is doing.
Instead, a market index offers a snapshot, either of the market on the whole or a specific segment. It’s a collection of stocks or other assets that represent the market.
For example, the Nifty 50 tracks the performance of the 50 largest companies by market capitalisation listed on the NSE. The Nifty Total Market Index represents the entire Indian stock market, the Nifty Midcap 150 focuses on mid-sized companies, and the Nifty Next 50 tracks the performance of the next set of 50 large companies after the Nifty 50.
This means, that no matter which aspect of the market you want to track, there is an index that can suit your purpose. Investors often use these indices as benchmarks to measure the performance of their portfolios.
Why Should You Invest in Indices?
There are several advantages of investing in indices.
1. Diversification
The saying “Don’t put all your eggs in one basket” is especially true for the stock market!
Investing in an individual stock can be quite risky — what if the company fails?
Instead, if you spread your assets across the different stocks in an index, it can offer you diversification and reduce any risk associated with specific stocks.
For example, if you invest in the Nifty Total Market Index, your investment is spread across 22 different sectors. So let’s say one sector underperforms. During that time, other well-performing sectors in the portfolio can balance out your returns.
2. Ease of Access
It is very easy to invest in indices through index funds or ETFs. For the former, you can buy units of index funds through any AMC or distributor platform. With the latter, you can buy and sell ETFs on the stock exchange just like normal shares.
Apart from that, index funds are also known for their low management fees. The expense ratio can be quite low as compared to other actively managed funds.
Types of Market Indices
- Broad Market Indices
Broad market indices, like the Nifty 50 or the Nifty Total Market Index, include a wide range of stocks. They provide a comprehensive overview of the entire stock market. Even among broad market indices, there are varying degrees of inclusion.
For instance, the Nifty 50 contains the fifty largest companies listed on the NSE. This means, there is diversification in terms of the sector inclusion, but not in terms of the market cap.
On the other hand, if you consider the Nifty Total Market Index, it includes the top 750 companies listed on the NSE by market cap. This means, the components range from large-cap, to micro-cap, in this case.
- Sectoral Indices
Sector-specific indices focus on specific industries or sectors within the market. For example, Nifty Bank includes the twelve largest banks listed on the NSE. Nifty IT, on the other hand, includes the ten largest IT companies on the NSE.
These indices are useful for those who want to target specific areas of the market.
How Index Investing Works
Index investing is based on the principle of passive investments.
This means you replicate the constituents of the index, the Nifty Total Market Index, for instance, and then simply let it be. It is an ideal method of long-term investments because the amount grows consistently when left to its own devices.
The other style of investing, active investments, involves a more frequent change in the portfolio in response to the market conditions.
While passive investing attempts to replicate the market index, active investing attempts to outperform it.
Benefits of Index Investing
1. Consistency
Since this style of investing aims to replicate the performance of the index, you can expect a level of consistency in returns over time. After all, even if individual share prices show fluctuations, the overall index generally performs well in the long run.
2. Simplicity
This style of investment is innately simple. There is no complicated analysis involved and no need to rebalance your portfolio from time to time. This means, that whether you’re a seasoned investor or a beginner, index investing is suitable for you.
Risks and Considerations
1. Market Volatility
Index investments are not, however, immune to market fluctuations. When the overall market experiences volatility or a downturn, the index will also be affected.
Having said that, these fluctuations are generally short-term in nature.
2. Tracking Error
The premise of index investing is based on your ability to replicate the constituents of an index. If there are tracking errors, however, inconsistencies can arise in the performance of your portfolio.
For instance, the Nifty Total Market Index is balanced semi-annually. You should make sure to adjust your own portfolio allocation after that, to ensure there are no tracking errors.
Conclusion
Investing in indices can be quite a smart method for beginners to start their stock market journey. After all, it offers a ready-made portfolio and all you have to do is replicate it!
Do keep in mind, however, that all stock market investments are subject to market risk and your portfolio will show the effects of market volatility even with index investing. As long as you stick to your investment goals and keep a long-term perspective, index investing can be a good approach!
