“Should I invest only in stocks or look at mutual funds as well?,” is a million-dollar dilemma that often every investor’s mind.
First of all, let’s be clear that there is no right or wrong choice of priority between mutual funds and equity; it’s subjective. Further, they are not mutually exclusive either; if equity is a parent, equity mutual funds are the children. An investor would be doing a great disservice by trying to pitch one against another. It would be like comparing apples and oranges.
In simple terms, if you are investing in a mutual fund then you let the expert (fund manager) take you to the destination you wish to reach to.
In direct equity investing, you are the person driving the vehicle and are responsible for making sure that you reach the destination. You would have to do some study on which route to take so that you not only reach your destination on time but also in the safest possible way. You need to continuously monitor the road (read: stocks) on which you ride. Also, you need to make sure that the route (again: stocks) that you pick will make you reach your desired destination without any accidents.
Here’s the difference between both direct stocks investing and mutual funds keeping all critical aspects of investing in mind.
Active vs Passive
If you have the time and the knowledge, direct equity investment can definitely work wonders for you. However, if you are not from the field and are likely to look at your stocks only once in a while or you are relying on your “friends” to advise you, then you should think twice before jumping into direct equity.
Stock investing will require you to be an active participant in the markets. You cannot afford to invest and forget about the stocks because then you will have to be super lucky to make money.
In mutual fund investment, even if you forget your investment, you will still make good returns because there is a fund manager looking after your portfolio, even in your absence. Mutual funds work well for passive investors.
Lump Sum vs SIP
Mutual funds are ideal investments for those who like to invest at regular intervals, say, on a monthly basis, as the basket can never be overvalued or undervalued.
With respect to direct stocks, you can buy when there is a perception that a particular share is under-valued and it can still go up. On the flipside, you could sell when you feel that it has reached its potential or it looks over-priced. It is, however, not as simple as it sounds. You would require technical knowledge of finance to judge a stock’s current position.
However, with a mutual fund portfolio, you could have stocks which are under-valued or overvalued but choosing to enter or exit stocks is the job of the fund manager. Ideally, systematic investment plans (SIPs) work very well for mutual fund investments.
Superlative vs Moderate
Stocks, as such, can give you extreme happiness or extreme despair. So, you can have a multi-bagger like TCS or Infosys or you could be saddled with a stock like Jet Airways or Suzlon. Direct stock investing returns could be super positive or super negative. Returns of a single stock can never be compared to a mutual fund scheme.
A mutual fund may not double your returns in one month but a stock has the capability to do so. However, the reverse is also true. A stock can test your patience for a very long time. In a mutual fund, on the other hand, you will make returns that are in line with the broader market trends.
Mutual funds invest in a large number of stocks which helps investors to diversify their investments. A well-diversified mutual fund invests in at least 40-50 stocks, which not only helps in portfolio diversification but also helps in reducing the concentration risk of the portfolio. In such a diversified portfolio, even if one or two stocks give negative returns, the impact on the entire portfolio will be very low. For an individual investor, it is not possible to keep track of such a large number of stocks.
Also, another great advantage of a mutual fund is that it will always have funds available to buy the same stock to average, if necessary, as it collects funds from different investors. In the case of direct stock investing, the investor will always have limited availability of funds.
Mutual fund investments should ideally be goal-oriented. What this implies is that you should redeem funds as and when you are near the associated goal, and not otherwise. In the case of a direct investment, you should sell a stock when you feel that the price has reached its potential or is over-priced.
Checks and Balances
Mutual funds always have checks and balances in place while selecting stocks for portfolio building. Even if a particular stock demonstrates immense potential, the fund will not invest too heavily in that stock, as it would increase the concentration risk. A mutual fund cannot invest more than 10% of the entire portfolio in one stock.
Direct equity investors may get lured into investing a majority of their portfolio in high yielding stocks, which will increase the concentration risk of their entire portfolio.
Access to Information
Mutual funds have access to considerably greater volumes of information than any lay investors. The fund managers have a battery of resources at their disposal and also have access to the managements of companies whose stocks they hold or may consider investing in. A retail investor does not have such an advantage and has to rely on external sources of information, which are available to the general public.
When a mutual fund churns its portfolio, an investor is not charged any taxation for it. Investors will be charged with capital gains tax only when they sell their mutual fund units.
Direct stock investors have to pay the capital gains tax on every sale transaction. Currently, even dividends are taxable in the hands of investors, whereas in a mutual fund, investors can opt for the ‘growth option’ and hence, pay tax only on redemption.
Regulated vs Unregulated
Direct stocks do not require any regulation as you are the master of your own trade.
Mutual funds, however, have to go through a rigmarole of compliances and they have restrictions in terms of what they can do and what they cannot do. They have to follow the mandate of the Fund as well as other restrictions related to exposure to companies and sectors.
Stocks have circuit filters. So, you may not be able to sell stocks when they hit lower circuits and vice versa. You will not face this issue with mutual fund investments as they have a net asset value and offer liquidity every day. Stocks may be illiquid but mutual funds have to provide you with liquidity every day.
Potential Returns/Performance Potential
Let us look at a return chart movement to understand the movements in stocks and mutual fund investments.
We have considered three stocks in the large cap space for our analysis. The first stock has given outstanding returns (Adani Enterprise); the second has tanked the most (Yes Bank) and the third has not seen much movement (ITC). Along with these stocks, we have considered the average category returns of large cap schemes.
These companies are considered only for the purpose of showcasing the drastic movement possible in individual stocks. In reality, it is unlikely that we would put all our money in one stock and the outcomes will depend on the amount that we invest in individual stocks. There is a chance that we might end up having higher exposure to underperforming stocks and less towards ones which are doing well.
If we compare this with mutual funds then the large cap schemes have delivered an average performance, without major changes upwards or down. This also shows that you will not get superlative performance (positive or negative) in mutual funds as compared to individual stocks.
Should You Opt For Direct Stocks or Mutual Funds?
An investor should always keep an open mind and invest through both mediums. Here are some factors to consider:
- There are more than 5,000 stocks which are listed in the equity markets and it is not possible for a lay person to track all these stocks. In fact, it is extremely difficult to manage a portfolio of more than 20 stocks.
- If your forte is large cap stocks, then you can participate in the midcaps and small caps through the mutual fund route and vice versa.
- Mutual funds lend themselves very well to the SIP investing model. They help you to achieve the benefit of rupee cost averaging. At the same time, you do not need to worry about whether the markets are expensive or cheap as you are buying every month. Direct stock investing is a good option for lump sum investing, as and when good opportunities present themselves.
- An investor can decide on a suitable ratio to be maintained between mutual fund and direct stock investments. This ratio can be determined by each investor based on the factors discussed above.
- If you are bullish on an entire sector and are not sure which individual stock will perform well, it would make sense to invest in a mutual fund with that sector in focus. For example, investors who are bullish on the healthcare sector and do not know which particular stock will do well, can invest in healthcare funds.
- Do not ever try to compare the returns on your stocks with that of a fund. There will always be a likelihood that you will outperform the fund. Direct equity investments have different points of entry and would not match that of the mutual fund. Hence one should avoid comparisons.
- Mutual funds are not only about equity; they also give you the opportunity to hold an investment that is part-equity and part-debt and, at times, even part-gold.
- In a mutual fund, you can actually forget about the investment and it will definitely grow over the long term as there is a professional managing it. The same is not the case with a stock; you would be really lucky if you had picked Wipro and quite unfortunate if you chose Kingfisher Airlines.
- Mutual funds are extremely good for building a goal-oriented portfolio, like for instance, for your retirement, children’s education, etc. Building a good stock portfolio can be good for leaving a good inheritance.