We covered what is Index, what is Index funds and its advantages in last episode.
Today in this episode, we will take a closer look at the risks involved in index funds and its return potential in detail.
Hello. My name is Vijay Mohan. You are watching Investment Insights.
To understand the risks in index funds, lets take a look at its historical returns first.
I downloaded this data from the investingsfunda.com site. It had data only till March 2020.
I added the data for 2021. Very interesting table.
It is showing beautifully that though the returns from BSE Sensex index is volatile and inconsistent in the short term, it is very predictable and consistent in the long term.
This table alone is good enough to understand the risk and reward of the stock market.
Each row is showing how sensex index has changed every year.
It started at 100 in 1979 and now is at more than 50,000.
In the first column Year 1, we are seeing how the index has risen/fallen every year.
We are seeing 3 year rolling returns data in the next column. That is, if we have bought this index and held it for 3 years, how would have been its annualized return?
That is what we are seeing from 1982 to Today for every 3 year intervals.
Next column is showing rolling returns for 5 years. Next 7, then 10, 15, 20, 25, and 30 years.
That is, the last column 30 years is showing the annualized returns data of the index if we have held it for 30 years for every 30 year intervals.
As BSE sensex started in 1979, we are seeing the rolling returns data from 2009 (1979 + 30).
Now lets take a look at the data in the bottom of the table.
Probability of loss for 1 year data is 13 out of 42. That is in the last 42 years, BSE Sensex index has given a negative return in 13 years.
The probability of loss %, the chances of negative return for 1 year is what we are seeing in the next row.
For one year, it is 31%. That means, the chances of getting a positive return is 69%.
OK. What is the range of return for 1 year? Thats what we are seeing in the next row as “Range of return”.
The range is from -47% to 267%. That is, each year the sensex index has given a return ranging from a loss of 47% to a gain of 267%.
Did you notice when this 267% return occurred? 1991 - 1992. That was the time Harshad Mehta had the market under his control.
If we see when the -47% occurred, no surprise there. It occurred very next year 1992 - 1993, the year Harshad Mehta’s scam came out.
By the way, did you watch Scam 1992 TV series? If not, definitely give it a try. Good one.
Other than this, market came down by 38% in 2009 because of financial crisis in US. This data is very important.
If the market goes down, we should know how much it could go.
When something like this happens, usually it bounces back immediately in the following year.
1994 gave 66% returns and 2010 gave 81% returns when the market bounced back from its bottom.
This is one year return. Now Lets take a closer look at 3 year rolling returns.
Now we are seeing the probability of loss as 7/40. If the probability of loss % is 31% for one year, it is 18% for 3 years.
We can see that as the investing period grows in years, the probability of loss comes down.
For 5 years rolling returns, probability of loss % is going further to 5%.
For 10 years it is 3%. From 15 years, it is 0 indicating that there was never a loss in the past when invested for more than 15 years.
Lets check out the range of return next. As the investing period of years go up, we can see the range of return is narrowing down.
For on year, it was -47% to 267%. But for 3 years it narrowed down to -15% to 62% of annualized return.
For 30 years, we can see a reliable 13 to 18% returns.
What can we learn from this data? In short term, market is very volatile.
For one year, the returns could range from -47% to 267%. But in long term, it becomes a more reliable 13 to 18%.
This is historical data. Future does not have to like this.
But we can use this as a rough guide for our future planning.
For this reason, all the financial planners recommend not to put the money that is needed for short term in stock market.
We should be investing only the money that is not needed for at least 5 years.
We cannot invest the money that is needed for daughter’s wedding next year. That is not a smart thing to do.
Now lets check out the movement of Nifty 50 index in last 13 years.
The index was at 2500 in 2009, but now it is above 15,500. If we look at its journey, it is not a smooth rise.
It was a rough journey with lot of rises and drops.
This chart shows us that we cannot expect a smooth ride just because we have invested in an Index fund.
More importantly, see the reaction of the market last year March when we realized the seriousness of Corona.
It has fallen sharply from 12,200 to 8,000. Almost 35% fall.
But now, it has risen up from 8,000 bottom to 15,500 - almost doubling up.
We should expect shocking movements like this in the stock market.
Now lets say that we got a job offer from one of these top 50 companies. Wouldn’t we join immediately knowing that it is in top 50?
Shouldn’t we have the same trust when it comes to investing in the same company? That too it is not just one company, but all top 50 companies - shouldn’t we have more trust on them?
All business has its good days and bad days. Would we sell and come out of a business during bad times?
We should do the same holding when it comes to investing in index fund as well.
We should not get out of the market selling when it crashes. Instead we should see that as a buying opportunity.
That is, we should see it as a chance to buy a good business at a cheaper price and should take advantage of it.
It is easier to say that. But what would we do?
When the market falls 30%, we will try to get out of it as if the world is coming to an end.
So if you cannot handle a drop like that, stock market is not for you.
Do not invest in it. Invest is other assets that suits you.
Now lets check out the chance of a stock market going down.
If we know that, we will know what to expect from the market. It will also give a confidence in the market.
This data is derived from 120 years of US stock market history. We can sue this as a guidance for Indian stock market.
We can expect the market to go down by 10% every 11 months.
Going down by more than 15% can be expected every 24 months.
20% - once in 4 years. 30% - once in 10 years.
40% - once in 20 years. Going down by more than 50%, 2 or 3 times in a century.
If we look at the history of US stock market, whenever it goes down like this, it bounces back in next few years and rises up to new highs.
So, though the market can go down like this in short term, we should realize that in long term it gives good growth and be confident in investing in an Index fund.
Many have asked the question of where to buy the index fund.
We can buy it directly from the fund house that offers the index fund.
Like SBI, Canara Bank, UTI, Motilal Oswal - you can buy it directly from them after opening an online account.
After opening the account, link it to your bank account, transfer the money, then buy it directly from them.
If you do not know the exact procedures, contact their customer service. They will direct you with clear instructions.
Before buying the fund, one important thing that we should know is, we should be buying a “Direct” fund, not a “Regular” fund.
Direct fund is offered directly by the fund house. Expense ratio will be lot cheaper.
Regular would be the same fund offered thru brokerages like ICICIDirect. They do not carry direct funds.
The problem with regular is, their fees is more than double compared to a direct fund.
Though it appears as a small difference in the beginning, it creates a big difference in the long term.
So avoid buying a regular, but buy a direct fund.
If you want to know which index funds to invest, watch the “Stocks Portfolio” episode in this channel.
That is all to know about “Index Fund investing”.
Now you know what to expect from an Index fund. Good Luck with your investing.
We will see how to save for kids education in next episode. Thank You.