Passive investing: how to get started

Passive investing: how to get started

Recently, a friend came to me and asked me a question that I have literally been asked hundreds of times in my life: "Raghu, how do I get started with investing?" He had some extra funds sitting on the side and wasn't happy with the returns he was getting at his local bank.

Although I didn't tell him, I was glad that he didn't mention the word trading, because although I strongly believe that all traders should trade through RKSV, I also strongly believe a trader should be educated in the basics of trading before jumping into the game. Investing, on the other hand, is a different ball-game altogether. This particular friend didn't know the difference between the Nifty and Sensex; he was an absolute newcomer to the world of share trading and investing.

In this scenario, 'passive investing' is what he was looking for. As per Investopedia, passive investing refers to "an investment strategy involving limited ongoing buying and selling actions". "Passive investors will purchase investments with the intention of long-term appreciation and limited maintenance," it adds. My friend did not know whether to purchase shares of Reliance, TCS, or Bharti Airtel. He probably didn't even know how to purchase shares. What he wanted was some sort of low risk, guaranteed investment plan that would generate returns better than what he was currently generating.

I'm not a big investor myself, so this was a perplexing situation to be in. I have been an active trader since I was 13, and so telling somebody how to get started with passive investing, to me, was the equivalent of a cricketer teaching somebody how to play baseball. As I said earlier, a different sport altogether.

And so I came clean: I didn't know much about how to get started with passive investing, but would do the homework and get back to him. And this is what I came up with:

Fixed deposits: Your best "bank" for the buck

Yes, that was a play on words. But in all seriousness, fixed deposits are an incredible way for an investor to lock in a guaranteed return on investment.

A bank fixed deposit, also called a term deposit, is an investment where the interest rate is guaranteed not to change for the duration of the investment, so you know exactly what your investment is worth.

Now, the catch with fixed deposits is that you must park your funds for the specified amount of time and meet all requirements. For example, the Punjab & Maharashtra Co-operative Bank promises 10 per cent return on annum for deposit amounts of less than 25 lakhs for a duration 13-24 months.

The norm in India is for banks to compound interest on a quarterly basis. Without getting into heavy mathematical formulas, what this basically means is that if I were to invest 25 lakhs at 10 per cent return on annum for two years, with quarterly compounding I would end up with:

Principal: 25 lakh

Interest accrued: 5.46 lakh

Total maturity amount: 30.46 lakh

Therefore, my effective annualised return is not 10 per cent but actually 10.92 per cent, due to the quarterly compounding.

Penalties levied for early pull out of FDs

The catch with FDs is that it is quite common for interest rates to change frequently, especially during times of volatile inflation and repo rate changes. Suppose you deposit your funds into an FD that is guaranteed to earn you 10 per cent per annum over the next two years, but two weeks later your find out that another bank is offering 10.5 per cent with the same requirements. It might be tempting to withdraw your FD and deposit the funds with the new bank.

However, you will most likely be levied a penalty. Usually banks levy a penalty in the form of 0.05-1 per cent lower interest. Essentially, this means that if you were to earn 10 per cent per annum, this has now been reduced to 9 per cent. So let's say that you invest Rs 25 lakh into an FD at 10 per cent return per annum but after a quarter decide to ditch the FD in favour of another bank. During the quarter, you would have earned Rs. 62,326 in interest income if no penalty was levied. But with a 1 per cent levy, you only earn Rs. 56,094 in interest, which is more than Rs. 6,000 gone due to the early termination.

All in all, fixed deposits are a great way to invest your funds. They are safe, guarantee returns, and do not require the investor to keep a constant eye on the performance of the investment.

Debt funds: an alternative to FDs

A good alternative to fixed deposits are debt funds, which invest in fixed income securities like bonds and treasury bills. They are a lot less risky than mutual funds and a good alternative to FDs for those seeking higher returns with a small risk appetite.

For many years the prevailing notion has been that fixed deposits are the best bet for conservative investors looking for fixed returns. That's not the case anymore. With more and more mutual funds offering debt funds, risk averse investors now have more options than they did, say, 2-3 years ago.

The biggest downfall with a debt fund is that there is some risk associated with it, while FDs have almost zero risk. A debt fund is a professionally-managed fund that invests in government securities, bonds, money market instruments and corporate deposits. Around 10 per cent of the portfolio is also dedicated towards equity investments; hence, debt funds are associated with some investor risk.

However, with risk comes rewards. Debt funds are significantly less risky than mutual funds, but because of the equity investments, professional fund managers are usually able to beat the returns of a fixed deposit scheme. Furthermore, debt funds offer investors a lot more protection against inflation vs. FDs. An FD is locked in; so if inflation rises considerably after an investor has parked his funds into an FD, there is nothing he can do about it. A fund manager of a debt fund, however, has a lot more flexibility. Even during times of heavy inflation, most debt fund managers are at least able to produce returns that are higher than the inflation rate. FDs cannot promise that due to their structure.

Do some research!

If you're looking to get into investing, especially passive investing, it doesn't hurt to do some research. A couple of great websites you want to check out are: Funds India and Scripbox.

Both these companies make it relatively easy and simple for one to get started with passive (or active) investing. If you already have a financial adviser, ask him/her about fixed deposit schemes and debt funds. If you have an appetite for more risk, you can also look into mutual funds.

Finally, if you're looking to eliminate all middlemen and invest on your own, start by getting to know the basics of investing. Start with a small account balance, set conservative and attainable goals, and keep educating yourself.

Ace investor Warren Buffett made his first investment at the age of 11. By the age of 13, he reportedly told a friend of his that he would become a millionaire by the age of 30. We all know what happened next: he went on to become the greatest and most popular value investor of all time.

What we also know is that if he had never started investing, he would not have become the person he is today.

Raghu Kumar is the co-founder of RKSV, a leading low-cost broking firm. The opinions expressed here are the personal opinions of the author. NDTV is not responsible for the accuracy, completeness, suitability or validity of any information given here. All information is provided on an as-is basis. The information, facts or opinions appearing on the blog do not reflect the views of NDTV and NDTV does not assume any responsibility or liability for the same.

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