The Orange Paper » Investing

Not Peter Lynch or a Warren Buffett? Try Index Funds

Austin — Sun, 07 Sep 2008 07:19:47 +0000

Everyone might be familiar with mutual funds especially ELSS (Equity Linked Savings Scheme) coz that seems to be one of the favourites with salaried-class people. After all, it’s eligible for that deduction under Section 80C and plus has a potential to give you returns far better than traditional investment avenues such as Provident Fund (PF) and National Savings Certificate (NSC). However, investing in ELSS means a lock-in period of 3 years.

Consider this – you’ve already invested in ELSS and have some extra money that you wish to invest in stocks. You could be one who is a pro when it comes to investing directly in stocks. Or you could be someone who depends on friends / family for guidance. Then there are times when you really don’t have the time to track the stock market, more specifically, trying to figure out which are the stocks that you should ride your money on. In such a case, index funds are a good avenue to look at.

What is an index fund?

The average opinion of the stock market is expressed through a stock market index. While following an indexing strategy the idea is to try and earn similar returns as given by a stock market index. One way to execute this strategy is by investing in constituents of a stock market index in the same proportion as their proportion in the index. But, this is a complicated strategy for individual investors as weight-ages keep changing and the investor will have to keep adjusting investments all the time. The other way is to invest in an Index fund – a mutual fund that collects money from investors and invests in stocks that make up a stock market index in the same proportion as their proportion in the index.

What is the logic behind an index fund?

It’s very difficult for an investor to keep beating the market. In the last two decades more than 85% of the fund managers in the United States have underperformed the S&P 500, one of the most broad-based indexes in the US. May be a Peter Lynch or a Warren Buffett can keep doing it all the time, but of the lesser mortals very few are able to do it consistently. Given this why not just ride the market? And this is the very reason that led to the innovation of an index fund.

As the US equity markets evolved, mutual fund managers realized that it was becoming more and more difficult to beat the indices, net of commissions, trading costs and taxes. Many mutual fund managers started buying stocks that constituted the various indices in the same proportion. And this became known as closet indexation. Out of this concept of index funds evolved. John Bogle was the first to launch an index fund. It was called the Vanguard 500 and it was an index fund based on the S&P 500.

What makes an index fund attractive?

Another reason that makes index funds attractive is their lower expense ratio. Expense ratio represents the expenses of the mutual fund expressed as a percentage of the total assets. Index funds do not require the services of high price fund managers or any sort of research. This tends to keep the expense ratios of the fund low. The Vanguard 500 index fund in the US has an expense ratio of 0.18%. The index funds in India do not have such low expense ratios but they are low vis-a-vis other funds.

Do index funds show returns exactly the same as indices?

All index funds do not return as much as their benchmark index. This difference between the returns from the index fund and the returns from the index is known as tracking error. This error occurs because of two reasons – the index fund may not fully track the index plus the index fund will have transaction costs to take care of.

This is a post from: The Orange Paper ~ A blog about Personal Finance, Indian Stock Market, Financial Planning, Investing, Wealth Building, Taxes and more.

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NSC and KVP take the demat route

Austin — Tue, 02 Sep 2008 18:01:26 +0000

photo by aubergene

National Savings Certificate (NSC) and Kisan Vikas Patra (KVP) are the two of the most commonest investment instruments in India. Well, if you have invested in these and you’re based out of Mumbai, you’re in for some good news.

The postal department has been running a pilot project in Mumbai to electronically credit NSC and KVP details in an investor’s demat account — just like shares — instead of issuing the usual physical certificates. Thirty five major post offices in the region (Mumbai, Thane and Navi Mumbai) are authorised to offer NSCs and KVPs in demat form. Now post offices in Mumbai are urging investors to opt for NSCs and KVPs to choose the demat option during the application process.

There are many advantages of getting them credits in the demat form. One, it ensures that investors don’t lose sleep over protecting the paper certificate form damages i.e. bad weather, theft, mutilation. All that the post office has to do is inform the National Securities Depository Limited (NSDL) which creates a demat account and displays online the investment amount, the maturity value and date.

Needless to say, the demat form makes visits to the post offices totally redundant, saving you a lot of time. At present it takes ‘at least’ 10 days to issues the NSC / KVP certificate if the investor has paid by cheque. The postal department may soon extend this facility to other metros.

This initiative by the postal department is commendable. As they say, better late than never

10 reasons why it still makes sense to stay invested

Austin — Sat, 01 Mar 2008 08:58:41 +0000

Markets have come down from their recent highs in the past few weeks. While some of us might be thinking of cutting losses and putting money in safer havens, there are more than one reasons still favouring the equity markets. Feel free to agree/disagree to any or all of the reasons, after all it’s your money so you’re the one to decide if you would want to buy, sell or stay invested.

#1. Long-term plan: Wasn’t your investment in that stock supposed to be long term? Then why sweat in the so-called blood bath that the street has witnessed? The basic principle that often gets buried in a bull market situation is that one should make investments with a long-term perspective. “Any serious investor should remain invested in stocks, no matter what the current market situation is, for a couple of years but if the idea is to make quick bucks, probably he should sell and walk away,” says Value Research’s chief executive Dhirendra Kumar. The intervening years may be volatile but the light at the end of the tunnel is what we all should look forward to.

* UPDATE *
In his yesterday’s budget speech our Finance Minister Mr. P. Chidambaram has proposed an increase in the short term capital gains tax from the current 10% to 15%. You still wanna play short-term? Think again!

#2. Value-picking: It’s raining discounts, SALE SALE. Perfect time for value picking, isn’t it? Stocks you always wanted to own but deferred, thinking they are a little overpriced. Experts believe that this is the opportunity to buy stocks, now available at better valuations. It’s like picking your favourite stuff from a superstore at, say 20-50% discount. So, hurry while the offer lasts.

#3. Diversify: We all are aware of the need to diversify our investments, not just in different asset classes but also within classes. So if you had failed to do so, this is the time to add stocks of sectors missing in your portfolio. It might be that you had picked up stocks from sectors expected to give good returns in past but now have run out of favour. “Sectors that will participate in India’s growth momentum will be telecom, banking & financial services and engineering & construction,” said Birla Sun Life Mutual Fund CIO A Balasubramaniam. So take your pick from the buzzing sectors of today, now.

#4. E for Economy, I for Intact: The growth story of Indian economy is largely in place. There were signs of some softening recently but again such policy matters are gauged with a long-term perspective. “There are no reasons why the outlook of Indian economy in the foreseeable period should change. Huge investments lined up in Indian companies are going to drive the economy further. Also, India’s contribution to the world GDP is on the rise and the current market situation is just a reflection of the global markets.

#5. Bottom fishing: There are talks that the markets may have bottomed out. Which means one can make fresh investments during this downturn. Did anyone ask what if the markets correct further? Probably, it will be an even better buying opportunity!

#6. Invest step by step: Time spent trying to time the market is better used analysing stocks good for holding in the long term. No one can time the market; it’s like saying ‘when the next earthquake will hit Delhi’ with surety. Here, the rupee-cost averaging strategy becomes even more important. By doing so, the ups and downs of the market get smoothened out by investing a fixed amount of money on a regular basis over a longer period irrespective of the market situation.

#7. Why hate volatility: But markets are that way, or else how did we get the terms bulls & bears. “Markets by their very nature move up and down. The real nature of the market doesn’t get reflected without this. In fact, volatility gives the chance to fund managers and small investors to revisit the market and pick stocks.

#8. Get Set Go: If you haven’t made investments in equities but always wanted to, now is the time to get started. From 21k level, not too long back, the Sensex is now trading in the 17,000-18,000 range. So, what are you waiting for? It’s all yours.

#9. Taxes Times: How can we miss on taxes? Actual returns on any investment are known only after factoring in how much tax we pay on the gains. As far as equities are concerned, one is liable to pay short-term capital gain tax if investing in equities (stock per se or equity funds) for less than a year. This means one can save on these taxes by playing ‘long’.

#10. Returns: Ahhh, wasn’t this the MAIN motive of investing in the equity market? Sensex alone has given a historical record of 18% in the past 20 years or so. This means that if we simply invest in index stocks every year, the investment will generate better returns than from other avenues like FDs, NSC, PPF, post-office saving schemes, etc.

Still not convinced? Well, then you should try the Mutual Fund route. Research on the fund(s) you would like to buy according to your financial needs and go for it!

Investing Is Like Dating, Marriage and Marriage With Children

Austin — Sun, 24 Feb 2008 08:26:08 +0000

Investing in stocks and mutual funds has been compared to dating, buying investment properties like a marriage, and starting up a business like being married with children. I am beginning to find out how true it is.

Why are buying stocks like dating? For a start, you can get in quickly and easily. With some capital, you just need a broker, or an online account, and you can start buying stocks right away. There is no huge commitment involved. You can get out as easily, almost instantly if the price is right.

For many, the initial decision as to which stock to buy does not involve much thinking or time invested at all. The returns may be small compared to the other investment vehicles though. But once purchased, the stocks themselves require very little maintenance.

My first experience with investing was buying stocks just based on hot tips from friends. As expected, I lost money. Fortunately, I was able to get out fairly quickly though it was an expensive lesson.

I have since learnt to be a little wiser. And while I am not of the level to be considered a professional investor, I do hope I am now nearer being called an investor than a gambler.

Fans of Warren Buffett will not agree with the above analogy, of course. A true fundamental investor puts in a lot of leg work and spends a lot of time reading and understanding companies before he buys them. And when he buys, he is confident enough to make a substantial investment, and then to ride out the market’s ups and downs. Such an investor’s holding time is forever.

Now buying a property is quite different. Certainly, it does take a lot more time and running around to find a property that is suitable.

One has to find a property in a decent location. The property has to be in a decent condition, with a good rental yield. Some basic work needs to be done to make it suitable for rental. Bankers have to be consulted as not many have the cash to pay for a property without taking a loan. Calculations have to be done to see whether the rental income after deducting costs of the loan, maintenance and so forth make the investment worth the while.

But once all the initial groundwork has been settled, most of the time, the investor can then sit back and reap the reward of his efforts as he collects his rental cheque every month.Once in a while, parts of the property break down, or tenants may give some trouble, necessitating some work on the investor’s part. It does seem to be a bit like a marriage.

So why is starting a business like being married with a baby? I guess it means you are now totally committed and stuck! You have to give birth to a business, nurse it as a baby, pouring time and money into it to help it grow, all this while, not expecting much from it, in the anticipation that one day, it will grow big enough to support you many times over. To take money out of a business too soon would kill it.

And just like real children, there is no guarantee the business is going to turn out as you hoped. In fact, nine out of ten businesses fail. It is like bringing up a child only to find he has turned into a useless ungrateful adult who refuses to leave home and prefers to live off his aging parents.

With such dismal statistics, people who think about starting businesses are advised to plan to fail ! It has to be factored in. Failing is not enough. One has to learn from the mistakes and change. So following through with this logic, the faster one fails and learns from one’s mistakes, the faster one can progress. There is no need to know all the steps to getting from Point A to Point B, as long as you know where Point B is. The steps will slowly come.

So why advise someone to go into a business at all? It really depends on what the person hopes to achieve in life.

For someone who values security, the risks may not be worth it. It may be better to find a good mutual fund and let the professionals handle it. But for those who value freedom, the potential rewards of a good business returning unlimited amounts of money so freeing them from having to work may be worth the risks.

It is up to the individual to decide whether he wants to continue dating for the rest of his life, or commit himself to marriage and possibly children.