Success in investing is doing two things. Investing early and investing long. Albert Einstein had said, “Compound interest is the eight wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
To give an example: An amount of Rs 1 lakh invested at a 12 per cent annual return will rise three-fold in 10 years, ten-fold in 20 years and 30-fold in 30 years. Your money invested today will multiply every year in 15-20 years.
But there’s a caveat. Warren Buffett has said: “Rule No 1 — Never lose money. Rule No 2 — Never forget Rule No. 1.”
Compounding formula breaks if investments are sold at losses, and all those gains that one expects to benefit from long-term investing vanishes.
In equity investing, compounding does not work straightforwardly. There are good times, and there are bad times. Investors tend to lose discipline, especially during bad periods, and therefore lose out on long-term benefits of compounding.
Hence, invest early and invest long.
How not to choose investments
- Invest regularly: Disciplined investing requires investors to invest periodically. Invest higher amounts as the markets go higher. People who waste their time thinking they have missed a a bus will not be able to maximise long-term returns. A SIP is a great strategy to maintain discipline
- Track record: Blindly looking at short-term track records and choosing investments will lead to disappointments. Selling track record is the easiest way to sell funds, and so investors should look deeper into strategy and philosophy before proceeding. Investors should also watch out for funds that post extra-ordinary returns (eg 20%+ higher than average). The probability that the fund delivers the same in the future should be questioned.
- Debt investors looking at yields: Investors using yield as a measure will end up buying risky debt investments (credit funds) or investments that are very volatile (example, 30-year bonds).
- Market timing strategies: Various studies have shown that market timing destroys more value than it creates. For a long-term investor, it’s always a good time to start investing, especially if you’re going for SIPs.
- High fees - Investors should look out for fees that are higher than usual. There are a small number of instances where fees are justified, but overall, investors should avoid paying too many fees.
How to do it the right way with index funds
- Simplicity: Index funds provide a whole level of simplicity to the process of deciding funds to buy for long-term investing. Instead of choosing between hundreds of investment products, index funds are stress-free and based on their track record, they are really effective investment products.
- Look at living costs: The whole point of investing is to create an income that grows faster than living costs and save for retirement. Inflation is the biggest enemy, and equity is the only asset class today that beats inflation. Almost every broad-based index fund or a benchmark has surpassed inflation and will continue to beat it going forward.
- Focus on goals, not returns - Goal planning entails planning a SIP amount every month towards a long-term goal. Goal-planning helps in maintaining discipline and also helps investors see and track progress. Index funds have track-records of over 15-20 years, making planning goals easier and dependable.
- Focus on asset allocation: Based on numerous studies, 90 per cent of the long-term returns are because of asset allocation and not which fund one buys or sells. Index funds are great for asset allocation. Asset allocation should depend on the risk profile of an investor. A conservative investor investing in high-risk strategies will find it hard to hold to investments for long periods of pain.
- Rebalance portfolio periodically: A successful index fund investor should rebalance his/her portfolio at least once a year. If rebalanced with discipline, investors can expect to get additional returns. Rebalanced portfolios do better than static portfolios.
- Lower costs: Investing in index funds mean more money working for the investor. Costs add up in the long run. Focus on risk, not return: Index funds provide a level of risk that is consistent with time. A large-cap index fund is less risky than a mid-cap one and so forth. This relationship may not be evident in other funds. As they say, returns are volatile and hard to predict, risk is not.
- No churn: Churn is also an enemy of the investor and leads to less long-term returns. Every strategy has good and bad periods. So, investors should only churn for reasons other than returns. As index funds do not underperform the benchmark, there’s no reason to churn index funds.
- Time: Charles Schwab has said, “Time captures the economy’s tendency to grow. It also helps you get past downturns and recession.” Other risks include funds merging and closing down.
Successful investors are ones who invest early and invest long. Index funds help in making this process easy, economical and effective.
The writer is head of passive funds, Motilal Oswal AMC