Investment in stock means purchasing a share in a company. For investors who have sound financial and stock picking knowledge and have a high risk-taking capacity, investment in stocks can be an ideal choice. An index fund offers diversification through a combination of many stocks bundled into one investment. These are ideal for investors who are risk-averse and those who want to avoid the process of selecting stocks/mutual funds.
If statistics are to go by, approximately 18 million people invest in the equity markets in India. While this may look like a small number compared to the country’s population size, it is far bigger than the number of people who invest in index funds. Primarily because index funds are still considered new and investors are unaware of their benefits.
Investors may get confused while choosing between stocks and index funds as both come with certain advantages and disadvantages. Here, we will aim to demystify these two forms of investments and help investors make an informed choice.
What is an Index Fund?
Here is the meaning and generally-followed investment strategy of index funds:
Meaning of Index Fund
An index fund is a form of mutual fund which designs a portfolio based on the composition of the chosen market index, such as Sensex or Nifty 50. Index funds invest in stocks as per the index’s stock constitution. The reason for replicating an index’s stock composition is to try to replicate its performance. This comes at a minimal cost considering that index funds are passively managed and do not require a fund manager to do the stock selection.
Investing in Index funds
- What type of investors invest in index funds? – Index funds are opted by investors who are mostly risk averse and aim for predictable returns in the long run. Investors who do not want to get into extensive tracking often prefer index funds. If an investor wants to have equity exposure but not necessarily the associated risks, he/she can choose a Sensex or Nifty index fund.
- How they track various benchmarks? – An index fund tracks the chosen benchmark index by building a composition of stocks in the same proportion as the index. Thus, if a share price in the index moves up, so does the index fund price and vice versa. Since index funds track a benchmark index, these are called passively managed funds.
- Why investors prefer index funds – Investors prefer Index funds since they allow the ownership of a variety of stocks. This results in diversification combined with lower risk and comes at a low price. Index funds are also highly liquid, as investors can move in and out of the investment at any time. Therefore, most beginners find index funds to be better investments as compared to individual stocks.
What are stock investments?
Let’s now have a look at the meaning and strategy of stock investments:
Meaning of Stocks
In basic terms, when an investor buys a company’s stock, he/she owns a small piece of that company and this is called a share. Investors invest in stocks of companies that they think will increase in value. If the value of a company rises, the company’s stock price increases as well. The investor can then sell the stock for a profit.
Investing in Stocks
- What kind of returns do stocks offer – Stock returns can be gauged from the long-term performance trends of the specific stock. When investors put their money in a stock, they expect price appreciation and dividends to gain profits. Stocks can also have negative returns depending on multiple factors like company performance, business segment, market trends, etc.
- How investors have gained from stock investments – Soaring share prices have a tendency to attract more investors as people look to make faster profits through stocks than wait for mutual fund returns in the long run. However, stock market trends show that investors who have remained invested in stocks for the long term tend to gain positive returns as compared to short-term investors.
- Risk of stock investments – Several risks can be associated with direct stock investments, some of which are company risk, market risk, tax, changes in regulations, inflation, etc. Equity investments often go by the high risk-high return concept.
- Requirements for stock investments – Investors need to have a Demat account to trade in stocks. There is also the cost of brokerage associated with every stock purchase/sale. Thus, stock investments can end up being costlier than index funds. Before investing in stocks, investors must also gauge their level of expertise with stock selection, else it can result in significant losses.
An investor always has the choice of actively being involved in an investment or being a passive investor. An active investor takes on stock selection risk to gain higher returns. A passive investor is looking for moderate-low returns by avoiding company or industry risks. By looking through the strategies involved in stocks and index funds, investors can decide on personal investment goals and accordingly pick between the two options.
Frequently Asked Questions
If an investor likes to be passively involved in an investment, index funds may be the right choice. On the other hand, stock investments are ideal for those who have the expertise and intention to be actively involved in stock selection.
Index funds are often less volatile as compared to stocks. However, the volatility depends on the underlying index and how it fluctuates. Stocks could be highly volatile in the short run, but large-cap stocks may fetch stable returns in the long run
For an experienced investor who has sufficient knowledge of the functioning of stock markets, individual stocks can fetch better returns as compared to index funds. This is because the investor can take on higher risk for the expected higher returns from individual stocks. Index funds are passively managed and are mostly meant for investors who prefer low risk-low return type of investment.
Most experienced investors prefer to buy stocks when the prices are at their lowest. This depends on the market performance and other macroeconomic factors. However, there is no perfect time for investment in stocks, as the timing should mostly depend on personal investment goals.
Investors who are just starting off in stock investments must first get educated about stock market terminologies and functioning. It is ideal to start with small investments and check the risk/return performance to develop a sustainable investment strategy in the long run.