Passive management through index funds offers a simpler way of investing with the potential to grow your wealth over time. Index funds are a type of mutual fund that track a market index, like Nifty 50, with the same proportion of stocks as the index. It means when you invest in an index fund tracking Nifty 50, you are investing in the same 50 stocks that constitute Nifty 50. Here, the fund manager simply mimics the benchmark and maintains the composition.
Therefore, with index funds, you don’t need to be an expert in the stock market to get exposure to different assets or actively manage your portfolio. All you need to do is understand the basics of investing in index funds and follow these five simple steps to invest as a smart investor.
- Understand your risk tolerance
Index funds may be considered low-risk investments due to their passive investing nature and diversification benefits, but they still expose investors to some degree of risk depending on the types of securities held within the fund. The risks in index funds are directly aligned with their benchmark index’s risks. For example, index funds holding stocks/equities as their underlying securities carry relatively high investment risks.
So, understanding how much risk you can handle with different index funds will help guide your investment decisions and ensure that you don’t take on more than what’s comfortable for you financially.
- Research and compare funds
Once you understand your risk tolerance, research the various index funds available in the market and compare them based on their performance, fees, past returns, etc. It is important to choose an index fund that has consistently performed well over time (at least three-to-four years) and has low fees associated with it. Doing so can help you identify an index that aligns with your own risk tolerance, investment objectives, and return expectations.
- Go for a Systematic Investment Plan (SIP)
Investing with a lump sum can be risky because if there is an unexpected market decline, your entire investment could be at risk. To ensure that you don’t put all your eggs into one basket, it’s best to invest systematically via SIP.
An SIP helps you regularly invest in your chosen mutual fund scheme and allows you to spread out your investment over several months or years, depending on your timeline and financial goals. This helps reduce risk by ensuring that not all your money is invested at once – instead, it is invested gradually, which allows for more stability during volatile markets.
- Invest with a long-term approach
While there may be periods of volatility or bear markets, these shorter-term fluctuations can often be offset by positive returns over time with a managed approach. Keeping this in mind, it is important to have a long-term approach with index funds. They may also experience volatility in a short period; however, over time, these fluctuations can even out as new investments come into play.
- Choose a low-tracking error fund
Invest in index fund schemes with low tracking errors for better long-term returns. If there is a high tracking error, it implies that your returns may vary significantly from those expected from benchmark indices due to higher expenses, a risky portfolio management strategy by the fund managers, problems in purchasing/selling underlying index stocks, etc.
Closing thoughts
Investing in index funds can be an affordable way for investors to gain exposure to different asset classes with minimal effort required on their part. But to invest like smart investors, take note of the tips listed above and, most importantly, consult a financial advisor to craft a personalised investment strategy and a well-rounded portfolio that offers both growth potential and stability.
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