January 2023

<aside> <img src="https://prod-files-secure.s3.us-west-2.amazonaws.com/2df93aac-bfa8-4407-8a0f-fb03db36f6b4/29d84082-dc2a-4d48-81f0-43ca59d4f080/317750_linkedin_icon_(1).png" alt="https://prod-files-secure.s3.us-west-2.amazonaws.com/2df93aac-bfa8-4407-8a0f-fb03db36f6b4/29d84082-dc2a-4d48-81f0-43ca59d4f080/317750_linkedin_icon_(1).png" width="40px" /> Viswateja Krottapalli

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Ever had that friend who's always on about how they picked the perfect stock and made a killing? Yeah, we all have. But let's be real, for every stock market 'guru', there's a bunch of folks who lost their shirt trying to beat the market and I am no exception 🙂. That's where index investing comes in, and it's like the chill cousin at the family function who's all about keeping things low-key and steady.

So, here's the deal: index investing is like grabbing a slice of the whole market pie. Instead of trying to find the needle in the haystack (aka the next hot stock), you just buy the haystack! You're essentially betting on the entire market or a big chunk of it, like the Nifty 50 or Nifty 100, which is a group of 50 to 100 of the biggest companies in India.

<aside> 📢 Index investing is a type of passive investment strategy where an investor builds a portfolio designed to match or track the performance of a specific market index. These indices could be broad-based to reflect the entire market like the Nifty 50, or could be more specific, focusing on a particular sector or type of company. This strategy is built on the belief that it is hard, if not impossible, to consistently outperform the market. Therefore, rather than trying to beat the market, index investors aim to mirror the performance of the market as closely as possible.

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If you invest 10,000 every month into an index fund and you end up making 136803 at the end of the year, how do you calculate your rate of return?

136803 / 120000 = 14% is wrong as all the 120,000 is not invested in one go

IRR is the annualized effective compound return rate that can clearly define the return and in this case its 24%.

Let me Explain IRR with a simple example

Image you are investing the same amount of 10000 at the same interval of once every month in a Fixed Deposit with a annual compound interest rate of 12% an year. If you cancel the FD exactly at the end of the year, you will end up making around 128093.

Now if someone asks you on the what is the return rate of your investment vehicle ( FD in this case), would you say

a) 128093/120000 = 6.74% OR

b) 12% which is the published FD rate

Most likely it would be 12% as that is the published return rate of the investment

<aside> 📢 IRR ,Internal Rate of Return, is the annualized effective compounded return rate that can be earned on the invested capital. In a Systematic Investment Plan (SIP), which is a method of investing a fixed amount regularly into a mutual fund or similar investment vehicle, the IRR can be used to measure the return on the investment over the investment period. Since SIPs involve multiple cash flows at regular intervals (investments) and a lump sum amount that is expected in the future (the value of the investment at the end of the period), calculating the IRR for a SIP can help an investor understand the average annual return that their periodic investments have generated.

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13% return on Nifty 50 long term investment is a significant number as this sort of rate of return will double the investment value every 5 years and hence stands an attractive option for investors seeking a diversified, cost-effective, and relatively low-maintenance approach to building wealth in the financial markets.

Index funds asset value as of march 2023 stood at 1.67 Lakh crore compared to 69K Crore an year before clocking an asset growth rate of 143%, highest in the MF sector, thanks to the health returns in index investing.

However, should we expect similar rate of returns going forward ? How far has the recent sharp increase in indices post Covid 19 pandemic influence this 13% IRR. To understand this, I have looked at long term returns before covid 19.

<aside> 📌 The Data for all these charts are sourced from Google Finance. If you are interested, you can access live metrics from this sheet. It might hand for few secs as it has to download data live from Google Finance, so please give it a few secs to settle. https://docs.google.com/spreadsheets/d/1k4OWjm4nzhodDb7fQkRyH74KEsHTVWSnHhToatXOToY/edit?usp=sharing

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The story changes when you re-run the math with 15 years of data before Covid onset i.e. 2020. The 15 year IRR drops by 2 points to 11% from 13% as shown below. This 2 point difference might sound small, but on long term this translates to roughly 25 Lac difference on an investment of 25000 every month for 15 years. All other indices are also significantly lower.

However the point to note is the return on Nifty 50 has always been higher than the bank FD rates and so it is always advisable to maintain index funds in the investment portfolio to get higher returns