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Direct investment in Stocks versus Mutual Funds (MFs)?

This article compares mutual fund investments with direct equity investments. It gives pros and cons of each, and suggests what type of investors should invest in each.

 

How should you invest?

You are a savvy investor. You read a lot about personal finance and investing, and therefore you know very well that equities give the best long term, inflation beating returns among all asset classes.

You need to save for some long term financial goals, and obviously, stocks are your first choice. You decide to invest in a disciplined manner to achieve your goal. So, you open a depository account, a trading account, and start investing in stocks.

The question is – is this approach correct? Should one invest directly in stocks, or take the help of experts?

Well, the answer would vary from person to person. So, let me compare the two methods of equity investment, to help you find your own answer!

 

Factor 1 – Time

Many small investors “invest” in stocks for the short term based on tips and rumours, and that is the most inappropriate “investment” strategy. This is trading, and this methodology can suit only traders. They are the ones who invest huge capital and trade with large positions, such that even a 5 paise increase in a stock’s price is very profitable for them. But for small investors, it is a losing battle.

Investment in shares should be done only for the long term, keeping in mind the soundness of the company’s strategies and management. Investment in stocks, therefore, needs a lot of research. It involves fundamental analysis – a study of the fundamental factors that affect the performance of a company. These factors may include the industry in which the company operates, growth rate of the industry, domestic and international competition, overall economic scenario (interest rates, inflation, exchange rate, etc), and so on.

This research needs to be done not just before choosing a stock, but even for its continuous tracking during the entire holding period. This kind of research needs a heavy investment of time. Do you, as a small investor, have this kind of time to spare?

 

Factor 2 – Expertise

Researching a company requires a thorough knowledge of valuation and accounting principles, and interpretation of various financial ratios like RoE, RoCE, RoNW, etc. It would also require access to latest financial results and other financial information about companies.

Fundamental research would also require knowledge of the industry in which the company operates.

Do you have such access and expertise?

 

Factor 3 – Transaction Costs

As a small, individual investor, your transaction volumes would be very modest. This also means that most of the brokers would charge you the highest brokerage – remember, at most brokerages, the brokerage cost as a percentage of trade value decreases as your trade volumes increase.

This transaction cost has a direct and significant impact on your ultimate returns. And you prepared for this?

 

Factor 4 – Reaction Speed

If there is a sudden change in economic factors, and it changes some of the fundamental factors affecting the company, would you be able to think in a dispassionate, level-headed manner? Would you be able to act fast and react?

 

Factor 5 – Control Over Investment

How important is “control” to you? Do you want to decide how much is invested where? Or you can trust an external expert for your investments?

These are some of the factors that would help you in deciding whether to invest directly in the stock markets, or through mutual funds (MFs).

If we consider the profile of a typical small investor, he would have a full time job, and would be investing only to achieve his financial goals. He would not be an expert in valuation and accounting. He would also not have the time to research companies thoroughly.

So, as a general principle, it is advisable for small investors to invest through mutual funds.

 

The advantages of investing through MFs

  1. They have experienced fund managers, having a good understanding of stock markets.
  2. MFs hire researchers, who have an in-depth knowledge of various industries. They also understand various valuation principles well.
  3. These experts work full time on researching companies, and are therefore able to better identify good companies.
  4. MF researchers often talk directly to the management of the companies, so they get a better insight into the company’s strategies.
  5. Mutual Funds collect money from many investors, and invest collectively on their behalf. This obviously results in larger transaction volumes, which in turn results in lower percentage transaction costs.
  6. MFs manage very large sums of money, as they collect small amounts from many investors. This money is invested on many good companies. This means that if you invest in MFs, you can diversify very well even with small amounts.If you have Rs. 10,000 to invest, maybe you can buy a couple of shares in 2-3 good companies.
    This is definitely not diversification! But with the same amount, you can buy units of a diversified equity MF, and you would have a well-diversified portfolio!
  7. Since MFs are managed by fund managers whose full time job is to manage money, they can react to any sudden developments in a timely manner.

 

Disadvantages of investing in mutual funds

Please also keep in mind the following disadvantages of investing in mutual funds:

Lack of Control

Once you invest, you, as an investor, would not have any control of where your money is invested – it would be invested based on the MF scheme’s investment philosophy.(Note: This actually can be the primary reason for investment in an MF – since you don’t have the time and expertise, you trust the experts, and let them manage your money!)Therefore, you should choose the MF scheme carefully, such that its objective is in line with your investment objectives.

If you are convinced that a particular sector is going to perform well in the future, you can invest in a MF scheme that invests specifically in that sector – you can invest in a sector fund. Such schemes come with considerable risk, as they are not diversified, but this is the maximum control you can have while making MF investments.

No Customization

Since MFs cater to a very large client base, they can not customize their investments.

Management Fee

MFs charge a yearly management fee. This fee is charged to cover for research and other costs that the MF scheme incurs in the course of its investments. Since this is a yearly fee, it would have an impact on your returns.But, at the same time, one can also argue that this money is used to perform better in-depth research, and therefore provides a better overall return on your investment!

 

Now that you know the advantages and drawbacks of MF investments, you should be in a better position to decide whether you want to invest directly in stocks, or want to take the mutual fund route!

Happy investing!

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