A reader says, “I have been trying to get information on how to invest in Index Funds but could not find much info. I would appreciate it if you could provide your guidance on this”.
Our investing mantra is process-first, products-last. So, selecting an index fund should be the very last step. We recommend asking these questions before investing.
1. Why are you investing? What is your goal? It is common for young earners to say they don’t have a goal or want to build wealth. Financial independence by 50-55 should be the default primary goal. So focus on that.
2. How much should I invest? We recommend investing at least 75% of monthly expenses (excluding EMIs, amount spent for parents or children) each month for financial independence. The higher, the better.
3. How should I invest? If your goal is 15 years or more, we recommend investing 50-60% in equity and the rest in fixed income (this includes EPF, PPF, etc, if relevant). This is the initial equity allocation. This equity exposure must be gradually decreased well before the goal deadline. See, for example, Retirement plan review: Am I on track to retire by 50?
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4. How much return should I expect? The lower, the better! That way, you will be disappointed less! Remember, there are no guarantees, and returns are not something that we can control! See: Long-term investing in equity comes with no guarantees of success!
We suggest using no more than 12% returns from equity before tax, not more than 7% from tax-free fixed income, and 6% from taxable fixed income. Remember these are not returns you will get next year or the year after. You expect these returns after 15-20 years or when you need the money. The overall portfolio return will gradually decrease because you need to reduce equity exposure, as mentioned in point 3.
5. Finally, we are ready to choose product categories (not yet products!). Now, ask, why do you want to invest in index funds? Is it because they are doing well? Or because many people are talking about them?
Unless you are truly convinced that it is impossible to pick an active fund today that will beat the index tomorrow and that even today, half the funds in all categories do not beat the index, you may have doubts after you buy an index fund. You may become a half-passive, half-active investor with a di-worsified portfolio. So be clear about this.
For some data, see:
- Active Large Cap Mutual Funds vs Nifty 100 Performance Analysis
- Myth Busted: Active mid cap mutual fund managers can easily beat the index
- Which small cap mutual fund should I include in my portfolio?
Index funds eliminate fund manager performance risks and are the simplest, cleanest choice a young earner can make to build wealth while focussing on increasing income.
6. If you still wish to buy index funds, buy one Nifty or Sensex Index fund. That is it. No mid cap index funds, small cap index funds, or factor-based index funds. Keep it simple.
Our fund recommendations are:
- UTI Nifty Index Fund-Direct Plan-Growth Option or
- HDFC Sensex Index Fund-Direct Plan-Growth Option or
- HDFC Index Fund-NIFTY 50 Plan(G)-Direct Plan
See: Handpicked List of Mutual Funds (PlumbLine)