How retail investors can create wealth using the buy & hold investing strategy

Since a buy-and-hold strategy is essentially passive investing, first understand how actively-managed strategies work in a mutual fund scheme. Actively managed mutual funds look at beating the index that they have benchmarked themselves against. There is frequent buying and selling of stocks as per their reading of the markets. This requires them to be in tune with the market ups and downs and also about various stocks that they could pick.

A buy and hold strategy belongs to the other end of the spectrum, where the funds buy and hold a certain basket of stocks over a long time without frequent transactions or changes to the basket.

An index like the Sensex or Nifty50 is considered the barometer of the country's stock market performance. Indices are a basket of well-performing, financially sound companies picked from key sectors of the economy like information technology, finance, FMCG, oil & gas, consumer durables, etc. A buy and hold strategy advocates buying and holding the index stocks over a long time to build wealth. Passive investing is based on the premise that a market works efficiently and delivers long-term returns by buying and holding the investments.

A buy-and-hold strategy can be adopted by opting for either index funds or exchange-traded funds (ETFs). Both, index funds and ETFs mimic the exact composition of the index that they follow. For instance, a Nifty Index fund or ETF will have all stocks in the same percentage as on the Nifty 50 index. If Reliance Industries has a weight of 11% in the index, then 11% of an index fund's portfolio is invested in Reliance Industries.

One can buy and redeem an index fund from a fund house/Asset Management Company like any other mutual fund. The expense ratio of an index fund is far lower than an actively managed fund. The maximum average expense ratio of an active fund is close to 2% whereas the same for an index fund is around 0.15%. This difference in the expense ratio can make an enormous difference in returns when an investor remains invested in the fund for the long term.

An ETF is a basket of stocks that is listed and traded on the stock exchange. One can buy/sell a unit of ETF during market hours. The expense ratio of an ETF is lower than that of an index fund. But the key factor that should be considered while investing in an ETF is liquidity which is nothing but the presence of adequate number of buyers/sellers at any point for the trade to go through. This is unlike an index fund which can be bought/redeemed from the AMC at any time. In addition, one needs to have a demat and trading account to invest in these schemes.

A majority of the equity investments in mature markets like the US flow into passive funds. As equity markets in India get more mature, there are now fewer avenues for superior stock-picking, which makes it a stronger case for a passive, buy-and-hold strategy. Warren Buffett said, "If you don't make money while you sleep, you will work until you die". Adopting a buy-and-hold strategy by investing in the index is one way of making money while you sleep.