PASSIVE WEALTH CREATION

It is an established fact that over the long run, equities as an asset class outperform all other alternative asset classes including real estate. A RBI report on Currency and Finance, 1997-98 revealed the following returns over a 20 year period compounded annually:

Inflation    :     9.19 %

Gold        :    7.62 %

Bank FD'    :    9.19 %

Co. FD'        : 14.47 %

Equities        : 20.15 %
 

It shows that equities have spectacularly outperformed all other assets. I suspect that the difference would get even more pronounced if we were to conduct a similar study today.
 

It is clear that our choice of investments have to give us returns that beat inflation. A recent study revealed that only 2 % of savings in India are invested in equities. So, why are we Indians so averse to equity as an asset class? The reasons, perhaps, lie in the setbacks that Indian investors have received in 1992 and 2000. That apart, stock markets were regarded to be manipulated by operators and promoters had a reputation for unethical practices. Maybe investors who had burned their fingers were justified in having such beliefs.
 

But one cannot get away from the fact that our approach to investing in equities lacks discipline and is sporadic, with an overwhelming bias towards flavour of the month stocks. When stocks are down, we refuse to even consider them as investment options and when they go up, we chase prices which have already gone up substantially. This might work as a trading strategy, but is eminently ill suited to long term investing. The error is compounded when we go for trading, but fail to book losses and convert out trades to 'long term investments'.
 

A simple method for genuine long term investors to build wealth, would be to invest regularly in units of Index funds or Exchange traded funds (ETF') such as Nifty BeES. This strategy might not give you an adrenaline rush, but has some advantages which you might consider:

1. You invest in an index which is almost sure to go up in the long term, unlike some stocks which may simply disappear.
   
2. You invest regularly, in equal amounts every month, so that when markets are down you acquire more units and when markets are up you get less units, but the value of units already acquired in your account goes up.
   
3. You attain automatic diversification, thus avoiding the temptation to get into hot stocks.
   
4. You benefit from the growth in the economy, without any significant effort in stock selection or rebalancing.
   
5. Indices routinely weed out stocks which are no longer relevant and replace them with new stocks. You gain from shifting business trends.
   
6. You capture the long term effects of compounding, since your gains are embedded in the upward movement of the indices.
   
7. Since you hold for the long term, you do't have to pay any taxes, which increases the compounding effect.
   

 

You could do even better with actively managed funds, which have managed to outperform the indices, especially in the Indian context, but this comes with a dose of higher volatility.