How to Make Profit in Stock Market

In a country like India when we think of investing, we usually consider housing, gold, PPF among others, but rarely do we consider investing a significant part of our wealth in the stock market. Primarily because we consider investing in the stock market to be risky. While that is true to an extent, the right education can help in bringing down the risk significantly. 

For a beginner who does not have enough skill and time for identifying great stocks, the best way to invest in the stock market is to bet on the growth of the Indian economy through investing in the index (Nifty & Sensex) funds. From 1979 to date, Sensex has risen from 100 to nearly 50,000 today, which is a 500X in 42 years, a 16 per cent CAGR. The best part is, to achieve this kind of return one doesn’t require any investing skill. One simply requires the patience to buy and hold the index.

Unfortunately, the common retail investor in India still doesn’t take this route to create enormous wealth. One reason for that is the lack of financial literacy among retail investors and another reason could be the conflict of interest in the mutual fund industry. The awareness of index funds creates a direct threat to fund managers and distributors.

A regular plan of an active mutual fund (where the fund manager actively manages the portfolio and the distributor sells the scheme) sold to a retail investor usually has an expense ratio of around 2 per cent p.a., as it also includes the distributor’s commission. Even if a retail investor buys a direct plan, the charges could be 1 per cent p.a. On the other hand, a direct plan of a Nifty index fund can have an expense ratio of as low as 0.05 per cent - 0.1 per cent p.a.

Why are direct index fund plans cheaper? Since there is no distributor involved and the role of a fund manager in an index fund is just to replicate the composition and performance of the underlying index i.e., buy the stocks that are in the index, in the same weightage and rebalance the composition based on the changes in index.

Does an extra 1-2 per cent p.a. make a lot of difference? Let us assume you invest Rs 10,000 every year for 40 years at 15 per cent p.a. At the end of 40 years, you would have accumulated Rs 1.78 crore. The same amount invested for the same period at 13.1 per cent (assuming a difference of 1.9 per cent p.a.) grows to just Rs 1.04 crore. (41 per cent lower)

Won’t mutual fund managers deliver higher returns? Remember, it is the industry (companies collectively) that creates real value. The mutual fund industry just helps (though it is very important) to transfer the returns created by these companies to the investors. To transfer these returns, they charge money from the retail investors. If mutual funds could collectively create more returns, governments across the world would not worry about setting up any new industry and just depend upon fund managers to create value in society.

The investors have to realise that if one actively managed mutual fund does better than the economy of the country, there has to be another that does worse. So mutual funds collectively would do just as good as the economy minus the expense ratios (charges). Therefore, for the retail investors to get higher returns these charges need to be very low.

Will any equity mutual funds do better than the index? Quite possible, and that is the reason why Warren Buffett says "By periodically investing in an index fund, the know-nothing investors can outperform most investment professionals.”

Is it not better to buy the best equity mutual fund? The assumption here is that it is easy to pick the funds that are going to outperform the index, based on past performance or ratings. The funds that do well are flooded with new money and as Warren Buffett says “A fat wallet is the enemy of high investment returns.” Many investors would have realised this, as they start investing in the best mutual fund based on past performance and after a period many of these mutual funds start underperforming. Also because of the introduction of LTCG, if retail investors keep hopping from one mutual fund to another for higher returns, they would have to pay a 10 per cent tax to shift funds. The taxes paid have a huge impact on the overall returns in the long run. An investor can defer LTCG that adds immense value in the long run.

To further support our argument, let me share the performance of Nifty Fund/ETF as compared to actively managed mutual funds. According to valueresearchonline.com, (as of March 24, 2021) Nifty Bees (one of the biggest and oldest funds that replicate Nifty) in the last one year has ranked 16th out of 112 funds in the same category. Retail investors need to realise that by buying a Nifty index fund they were able to outperform more than 80 per cent of mutual fund managers. This data would help retail investors appreciate another Warren Buffett quote. “Paradoxically, when 'dumb’ money (know-nothing investor) acknowledges its limitations, it ceases to be dumb.”

Just to add, Nifty Bees ranked 20th out of 92 funds and 19th out of 53 funds in the last 3 and 10 years respectively. Not to forget that many funds in the last 10 years that did not do well might have either been discontinued or merged with other funds hence we have only 53 funds for comparison.

But isn’t this concept of index fund only for developed countries like India? Warren Buffett, a vocal proponent of index investing for beginners, in his interview with ET now when asked why he does not invest with fund managers in India who are outperforming the index said “That I won’t do. I won’t do that in the United States and I won’t do it elsewhere.”

I had the pleasure of receiving an email from John Bogle in 2016, the father of index investing, on my query of inadequate data to prove the underperformance of active mutual funds in India. He replied “When the data are at odds with the principle, I say, ‘well, then the data are wrong.’ And I'm pretty sure that's the case here.”

One example of the wrong data that he mentioned, could be the benchmarking of the performance of mutual funds to the index (excluding the dividends received while investing in the index). Only from 1st February 2018, all mutual fund schemes were mandated by Sebi to use Total Return Index – index returns including dividend to benchmark their performance.

But the good news is, increased awareness among investors has set the ball rolling for index investing in India.

The author is Founder & Director, Edge Institute for Financial Studies (EIFS)