Can Index Funds Make You Financially Independent?

Most top investors and investment books recommend people invest in index funds. Some go to the extent of saying that a person should ONLY invest in index funds to keep things simple and achieve financial freedom. In my last newsletter, I shared some financial mistakes that I made and what not to do. Let’s focus on wealth creation this week.

Morgan Housel in The Psychology of Money suggests that the best way to optimize your long-term investment returns is to invest the majority of your money into a diversified portfolio of low-cost index funds. Can creating wealth really be that simple? Let’s find out.

Index Fund AKA The Market

For those unfamiliar with Index Funds, here’s a primer. Say you don’t know which company is going to perform well and give you good returns. One of the options that you have is to reduce your risk and invest in the top 50 companies in India or the top 500 companies in the US. An index fund allows you to invest in a basket of companies and there are many index funds. For example, the Nifty 50 index fund comprises the top 50 companies in India. Whereas, the Standard & Poor’s 500 Index (S&P 500) index fund consists of the top 500 companies in the USA. So, when you invest in the Nifty 50 index fund, you are essentially investing in all the top 50 companies in India. Here is a list of top index funds in India and the USA.

According to Zerodha, Jack Bogle from Vanguard launched the first index fund in 1976 that tracked the S&P 500 Index comprising of the top 500 companies in the US. And IDBI Principal was the first one to launch an index fund tracking Nifty in India.

Scary Stats about Actively Managed Funds

An actively managed fund is one where an investment professional does research and analysis to hand-pick stocks that they believe will give better returns than an index fund. According to the 2020 S&P SPIVA report, nearly 90% of actively managed investment funds failed to beat the market over a 15-year period. In simple words, one would have gotten better returns by simply investing in index funds. These investment professionals have studied in Ivy League and work with some of the smartest people in the world. Yet, most of them cannot beat the market, i.e., an index fund.

So, why do we – you and me – believe that we can do a better job with limited time and research than most of these full-time brilliant investment professionals? It’s a question worth reflecting on because our ultimate goal is to make enough money to be financially independent with the least risk and effort.

Performance of Index Funds

According to MoneyControl, over the last 10-year period, the Nifty 50 index fund has given about 13% annual returns, while S&P BSE Sensex Index Fund has given about 12% annual returns. According to ETMoney, Nasdaq 100 has significantly outperformed S&P 500 in terms of performance. Over the past 15 years, Nasdaq 100 has delivered a CAGR of around 16%, while S&P 500 has returned about 8%.

To share another example, if you invested ?10,000 per month for the last 10 years in SBI Nifty Index Fund, you would have invested ?12,00,000 in total and its value would be ?23,43,579 today, giving you an annualized return of 12.85%.

Moment Of Clarity

• Clearly, investing in index funds is a long-term game. We are talking about investing each month for at least 10-20 years to make significant wealth.
• Compounding is the 8th wonder of the world and time is your only friend.
• Index funds are probably the simplest way to build wealth. No need to do a lot of research and analysis, or worry about global events, or anything else that typically goes with actively investing in stocks or any other asset class.
• Don’t sit on cash as the value of money erodes due to inflation. Historically, inflation has been around 8% in India.
• As a working professional or business person, you are not fully committed to actively researching and investing (obviously) in stocks. Investing in an index fund is a simple strategy to create wealth while you focus on developing yourself or your business to generate more income.
• Reduce Expense Ratio to increase returns: According to Zerodha, the average expense ratio of active mutual large-cap mutual funds (direct plans) is 1.28%. In comparison, the average for index funds is 0.31%. The costs add up and compound over time to reduce your returns.

?Action Of The Week

1. Go back to your financial goals and calculate if index funds can help you achieve any of your financial goals.
2. Research top index funds and compare the expense ratios. Then finalize the index funds that you plan to invest in. Now finalize the amount that you can invest in these index funds each month.
3. Start investing in index funds as soon as possible and don't stop come what may.

“Slow is Smooth; Smooth is Fast” ~ Jack Coughlin

I hope you enjoyed reading this newsletter. My focus is to help bring about financial literacy and help people become financially independent so that they can do things that they love doing; instead of being stuck in jobs that they don’t love!

Why not help me in this cause by sharing this newsletter with your friends?

Thanks for reading.

Darshan Doshi