Stock vs mutual funds vs index funds: How should a beginner invest in equities?

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Nadeem’s parents have just gifted him a lumpsum amount, which he wants to invest in stocks. He has been studying the market and the speed at which stocks recover even after a correction. His father suggests that he invests in mutual funds through SIPs. However, his friends urge him to consider a few funds with the best past performance. As a beginner, these ideas may help him buy an equity mutual fund but success is not guaranteed. Moreover, he is keen to know if there’s any solution for his lump sum savings. Everyone agrees that selecting mutual funds based on the past performance is an incorrect approach but still most of the advice is based on the same.

Stocks, mutual funds and index funds all have their advantages and with proper guidance, Nadeem can make the most of these as well. Investing in individual stocks can give him a higher level of control over his portfolio, where he can choose his allocation based on a specific industry and quickly exit once he earns a sizeable profit. Mutual funds will help him diversify easily with a very small investment.

In mutual funds, a dedicated fund manager who understands the Indian markets actively monitors and oversees fund so that inexperienced investors don’t have to sweat it out. MFs make it easy for rookie investors to follow a disciplined way of investing. An index fund is a mutual fund where the portfolio of stocks is not actively selected by a fund manager but is a replica of the index such as Nifty 50. The advantage of an index fund is that its portfolio is predictable and it comes at a lower cost. So Nadeem gets the benefit of diversification at a lower cost.

He can look at creating his equity portfolio, with strong companies and MFs. But how can he implement this? It is not feasible for a beginner like Nadeem to screen stocks and MFs and select the ones to invest in. This is the job best handled by his adviser. However, he should not be expected to follow someone’s advice blindly. What he needs is, understanding the process followed in making the recommendations and enough transparency to know that due process has been followed. This will enable him not only to invest confidently but also stay invested. For stocks, Nadeem can check how it is rated on its 10-year performance, future prospects, and its expected return on equity. For MFs, he can consider its investing style (momentum, quality, value, small cap etc), past performance (as compared to other funds), volatility and its risk-adjusted return.

Keen investors like Nadeem need to invest his lumpsum and monthly savings in stocks, mutual and index funds. Moreover, he needs to manage this portfolio as the market goes through ups and downs. He needs to do this with some understanding of the process and not act on random recommendations.

(Content on this page is courtesy Centre for Investment Education and Learning (CIEL). Contributions by Girija Gadre, Arti Bhargava and Labdhi Mehta.)

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