While all this may look like must-dos for investing, it involves a lot of effort, time, and cost. Despite all this, there is no guarantee that this strategy will work in generating long-term wealth.
Instead, a retail investor can adopt a simple buy-and-hold strategy to build wealth in the long term. Here is how one can go about it.
What is a buy-and-hold strategy?
To better understand a buy-and-hold strategy, let’s look at how an actively-managed strategy works in a mutual fund scheme. Actively managed mutual funds look at beating the index that they have benchmarked themselves against. There is frequent buying and selling of stocks as per their reading of the markets. This requires them to be in tune with the market ups and downs and also about various stocks that they could pick.
A buy and hold strategy (also known as passive investing) belongs to the other end of the spectrum, where the funds buy and hold a certain basket of stocks over a long time without frequent transactions or changes to the basket.
How to adopt a buy-and-hold strategy?
An index like the Sensex or Nifty50 is considered the barometer of the country’s stock market performance. Indices are a basket of well-performing, financially sound companies picked from key sectors of the economy like information technology, finance, FMCG, oil & gas, consumer durables, etc. Currently (as of September 2021) both Sensex and Nifty have stocks from the 13 best performing sectors of the economy.
So, a buy and hold strategy, advocates buying and holding the index stocks over a long time to build wealth. Passive investing is based on the premise that a market works efficiently and delivers long-term returns by buying and holding the investments.
“A buy and hold strategy (also known as passive investing) belongs to the other end of the spectrum, where the funds buy and hold a certain basket of stocks over a long time without frequent transactions or changes to the basket.”
Performance of buy-and-hold strategy
Index funds backed by the Sensex have given an average return of 14.37% as against a benchmark return of 15.67% for a 10-year period. Nifty 50 backed index funds returned 14.16%, as against the index’s return of 15.41%% during the same period. During the similar period, average returns of actively managed funds with Sensex as its benchmark was 13.6% and those benchmarked to Nifty 50 was 15.28%.
The returns shown here are calculated on regular plans of index mutual funds. Direct plans of mutual funds (introduced in 2013) are those plans which are bought directly from the Asset Management Companies without the involvement of a distributor/agent. These plans are available at a much lower expense ratio as no commissions are paid out to the distributors/agents from the Total Expense Ratio and therefore, better replicates the index returns.
On the other hand, SPIVA, the S&P Indices Vs Active Funds scorecard published by S&P Global, has revealed that actively managed funds have underperformed (especially in the Large Cap & ELSS category) their benchmark over 1-, 3-, 5- and 10-year periods.
Over the 10-year period ended December 2020, 68% of the large-cap funds and 58% of the ELSS funds did not meet index returns. Average returns for funds in the Large large-Cap cap category for 1-,3-,5- and 10- year periods were 14.98%, 8.34%, 11.77% and 9.69%, respectively, against the benchmark return of 16.84%, 9.94%, 13.22% and 10.11%.
Instruments that could be used with a buy and hold strategy
A buy-and-hold strategy can be adopted by opting for either index funds or exchange-traded funds (ETFs). Both, index funds and ETFs funds mimic the exact composition of the index they follow.
For instance, a Nifty Index fund or ETF will have all stocks in the same percentage as on the Nifty 50 index. If Reliance Industries has a weight of 11% in the index, then 11% of an index fund’s portfolio is invested in Reliance Industries.
Index Fund: One can buy and redeem an index fund from a fund house/Asset Management Company like any other mutual fund. The expense ratio of an index fund is far lower than an actively managed fund. The maximum average expense ratio of an active fund is close to 2% whereas the same for an index fund is around 0.15%. This difference in the expense ratio can make an enormous difference in returns when an investor remains invested in the fund for the long term.
ETF: An ETF is a basket of stocks that is listed and traded on the stock exchange. One can buy/sell a unit of ETF during market hours. The expense ratio of an ETF is lower than that of an index fund. But the key factor that should be considered while investing in an ETF is liquidity which is nothing but the presence of adequate number of buyers/sellers at any point for the trade to go through. This is unlike an index fund which can be bought/redeemed from the AMC at any time. In addition, one needs to have a demat and trading account to invest in these schemes.
What should you do
A majority of the equity investments in mature markets like the US flow into passive funds. As equity markets in India get more mature, there are now fewer avenues for superior stock-picking, which makes it a stronger case for a passive, buy-and-hold strategy.
Warren Buffett said, “If you don’t make money while you sleep, you will work until you die”. Adopting a buy-and-hold strategy by investing in the index is one way of making money while you sleep.
(The writer is Business Head, Finity, an app-based wealth management platform. )
Disclaimer: This post has been auto-published from an agency feed without any modifications to the text and has not been reviewed by an editor.