Index offers a very small sample comprising companies that may not be the best choices if assessed on parameters such as business fundamentals and valuations
When one talks about the stock markets and how it is doing; there is only one benchmark: What is the Index? Has it gone up or down? Investors are tuned out of a habit or a custom to look at the index. This is a mental heuristic: the short cut the brain takes to process information, it does not process full information and hence the wrong inference. There are a lot of mistakes human beings make, but since all of them are doing the same thing it becomes difficult for someone to challenge the status quo and do things differently. The acronym “TIPS” stands for “To Insure Prompt Service”. So when we visit a restaurant should not we be giving the tip before the waiter starts serving us? But we do the opposite; give a tip after the dinner. Why? Because it is a custom, everyone's doing it so we follow. Similarly we do that for the index also and thus land up making faulty investment decisions.
Firstly it is wrong to assume that Index is representative of the performance of the companies in the market. That means when the index goes up, all the companies listed on the stock markets are doing well and when the Index drops all are doing poorly. Here is where we suffer from looking at the wrong sample size to judge the markets. BSE Sensex comprises of 30 stocks and NSE Nifty comprises of 50 stocks. Is it right to judge the health of the markets with such a small sample size when over 6000 stocks are listed on the markets? That is one of the reasons that investors sway between greed and fear upon looking at the Index movements. When the Index goes up one may find that one’s portfolio has not gone up or even gone down and could be vice versa if the index goes down.
Moreover one needs to understand that companies come in to the Index because of market capitalisation and trading volumes. Quality of management, sustainability of business model, earnings potential and growth which usually are important factors for judging a company do not play any significant part. This means a newly listed company in a hot sector with a huge market capitalisation can enter the index and a good , well managed profitable company with a good dividend track record can exit the index if it does not have huge market capitalisation.
When telecommunications was a hot sector we had Reliance Communications without any track record replacing Tata Power a well managed, consistent dividend paying company. During the IT boom we had technology companies having a weightage of around 25% in the BSE Sensex. Satyam Computers entered the Index and out went Tata Chemicals. Similarly during the Power and Real estate fancy during the 2006/7 when had Reliance Power and DLF with huge capitalisation and hardly a track record to boast about entered the Index. Over time such entries have made investors a lot more poorer. On the contrary investments in the outgoing stocks makes sense as investors would be paying a low price for them as they have lost fancy. When you buy a fancy, you pay a fancy price and soon the fancy ends and you have a fancy loss.
The availability bias for index investing being safe and secure is so strong that investors have started believing it to be a fact. Why? Because there is no benchmark to judge the index. Hence with the entry of mutual funds we have funds offering Index Funds at very low fees. This is another availability bias that attracts investors to this passive form of Index Investing. What better can it be for a fund house to have an Index Fund which cannot be judged as there is no benchmark to judge it as the Index itself is the bench mark.
Investors need to understand the basics of investing and creating wealth. It is all about buying a business and not a piece of paper that goes up or down. One has to buy the business when it is available at an attractive valuation that is one pays a price which is well below its intrinsic value. Such times don't come everyday. It is a tough call and requires real hard work , knowledge, expertise and market experience from a money manager. There have been many money managers who have done exceedingly well in beating the index. So just to assume that you don't do any hard work and just buy the index and sit down and you will become wealthy is a misnomer. If one would have bought the BSE Sensex in 2007 when it was around 21000, today even at 28000 after 8 years he has not done well. Imagine the missed opportunities to by at index of 8000 in 2008, or at 18000, just a couple of years back? So in the end we come to the most important question: Are we buying when others are selling or are we chasing along with the others. If you have the discipline to go against the crowd you have won half the battle. The other half is having the patience to think long term.
If you are wary about investing directly, I suggest you choose a couple of actively managed mutual funds. They are an elegant and tax-efficient way of outsourcing your investment decisions. Besides, there is ample evidence which shows that there are several such schemes that have handily outperformed the index.
Before choosing an actively managed equity mutual fund scheme, I suggest you verify the following
- Is the scheme's portfolio 'truly' diversified across sectors, market capitalisations and countries? If not, avoid it.
- Does its investment mandate merely capture the latest investment fad ? If yes, steer clear of it.
- Are investors able to avail of all extant long-term capital gains tax benefits? Avoid it if this is not the case.
- Does it hamper your liquidity by imposing lock-ins ? If so, avoid it. While equity investing must be undertaken with a long-term view, compulsory lock-ins are a sub-optimal way of enforcing discipline.
- Do the mutual fund's sponsor and employees invest in the scheme ? If yes,you could invest along with them. Such ownership is an encouraging sign, as it is proof that they have their 'Skin In The Game' and that their interests are aligned with those of their investors. In other words, they will win only if you win.
- Is the mutual fund keen on directly reaching out to their investors through periodic interactions? If yes, it demonstrates that they consider investor feedback to be paramount and also their willingness to hold themselves out for scrutiny. Such funds are usually more investor-friendly.