Should you invest in Equity Mutual Funds or directly in stocks through a broker

If you want to invest in equities in India, there are two common avenues available to you. You can open demat and trading accounts with a stock-broker to buy or sell equity shares in the stock market. Alternatively, you can invest in equity mutual fund schemes. Mutual fund pools the money of different people and invests them in different securities like stocks, bonds etc. Many retail investors think that, whether you are investing in mutual funds or through stock brokers, at the end of the day, you are investing in stock markets and therefore both types of investments are the same; hence the dilemma, whether to invest in mutual funds or directly in equity shares?

In this article, we will discuss the key differences of investing in mutual funds and investing directly in stocks. Before we discuss the differences between mutual funds (henceforth, in this article, we will be referring to equity mutual funds as simply mutual funds) and stocks, let us spend some time understanding, the concepts of risk and return, attributes which are fundamental to stock, mutual funds and most other investment types.

Risk and Return

Risk and Returns are the two most important aspects of investing. We invest our money because we expect some returns. There are some investment products where you can earn returns without taking any risk, e.g. bank fixed deposits, traditional life insurance plans, government bonds, etc. However, risk free return is always the lowest expected return. Historically, in India, it has often been seen that, risk free returns, on a post tax basis, has not been able to keep pace with inflation over a long time horizon. If you want to earn higher returns, then obviously you have to take risks. Higher the risk, higher the potential return. Higher risk and higher returns are fundamental attributes of both stocks and mutual funds, but from an investor’s perspective the question is, how much risk is the investor willing to take relative to returns he or she expects from his or her investments? A deeper understanding of risk is required.

There are two kinds of risk in equity investments, Systematic Risk and Unsystematic Risk. Let us understand both types of risks, with the help of an example. Let us assume that, you invest in a bank stock. If the bank makes a quarterly loss, for whatever reason, then the share price of the bank will go down. This is a company specific risk. Even during the quarter, if the RBI, hikes interest rates, for whatever reason, the share price of banks (including the one, you have invested in) are likely to go down. This is a sector specific risk. Both types of risks, company risk or sector risk, are unsystematic risks.

Let us now assume that the Nifty, the index of the largest market cap stocks in India, of which your bank stock is also a part of, goes up or down by 3% in a day. If Nifty goes down by 3%, your bank stock, is also likely to go down in price. This is because your bank stock is part of the stock market, and therefore subject to market sentiments and risk. This is known as systematic risks or market risk.

We have no control over systematic risk and hence they are called uncontrollable risks. But we can reduce unsystematic risks; how? Let us assume, in addition to investing in the bank stock, you also invest in a pharmaceutical stock. If the pharmaceutical company that, you invested in, makes a profit in the quarter in which your bank stock made a loss, then the share price of the pharmaceutical company will rise, which may fully or partially, cancel out the loss made in the banking stock. Also, the pharmaceutical sector is unrelated to banking sector and therefore, even if the entire banking sector is affected due to an event, the pharmaceutical sector may not be affected. Therefore, by adding, a pharmaceutical stock to your portfolio, you will be able to reduce your overall portfolio risks. You will not be able to diversify all risks, because if the Nifty falls 3%, there is a chance that both your bank and pharmaceutical stock will fall, but you will be able to diversify the risks, that are specific to stocks and sectors. When investing in equities, it is important to have a portfolio mindset, rather than a purely stock mindset. With a portfolio mindset, you can diversify stock specific or unsystematic risks.

Risk Diversification in Mutual Funds with lower capital outlay

To create a diversified portfolio, you need to invest in a sufficiently large number of stocks. Let us assume that, you need 50 stocks to create to an adequately diversified portfolio. The share prices of the 50 stocks may range from Rs 50 to Rs 2,500 per share. Remember, you cannot buy fractional shares through your stock broker. Even if you buy just 1 share each of the 50 companies, assuming the share prices of the 50 stocks are uniformly distributed in the Rs 50 to Rs 2,500 per share range, your minimum capital outlay can be more than Rs 60,000. If you have to buy more shares, your capital outlay will be higher. To achieve adequate diversification through direct equity shares, you need a large capital investment.

Mutual funds, as discussed earlier, pool the money of different people and invest them in different stocks, in the right proportion, to create a diversified portfolio. The Assets under Management (AUM) of a mutual fund scheme is much larger than the investible capital of an individual retail investor. Each investor in a mutual fund owns units of the fund, which represents a fraction of the holdings of the mutual fund. Therefore, by owning mutual fund units, the investors have the beneficial ownership of a diversified investment portfolio. By investing, just Rs 5,000 in a diversified equity mutual fund, you can get diversification benefits that would have required a few lakhs, if you had invested directly in equity shares.

Therefore, risk diversification should be an important consideration because it reduces the probability of losses. In terms of risk profile, for the same amount of investment, diversified equity mutual funds are less risky compared to investing directly in equity shares.

Market expertise versus guesswork or tips

Most retail investors do not have the experience or expertise in stock selections. A large percentage of retail investments in direct equity shares are purely speculative or based on guesswork or tips from friends, relatives or their brokers. If you are investing in a stock, just because, the price has been rising for the last 3 weeks or a month or even a few months, it is still purely guesswork; just because a stock has been rising for the last few weeks or months, it does not mean it will continue to rise.

Mutual Fund managers rely on fundamental analysis to forecast long term asset prices. In fundamental analysis, they look at a variety of macro and micro economic factors. It also includes analysis of the companies balance sheets, income statements, cash-flow statements, management commentaries etc. Based on the forecast of these factors, employing a variety of methodologies, the fund managers and analysts forecast the future price of the asset.

It requires a certain set of skills and capabilities (which often includes speaking with the managements of the companies), which retail investors do not have.

Stock selection, requires deep expertise and experience, which only fund managers possess and most retail investors do not. Fortunately, mutual fund investors do not have to worry about stock selection. Mutual Fund investors have to select the right fund category and the right fund manager. As far as selecting the right fund manager is concerned, the investor has to look at the past performance of the fund manager and also the fund house. A fund manager who has performed well in the past can be expected to do well in the future as well.

Analyzing past performance of a fund manager may seem complicated, but there is a quantitative measure to analyze the performance of a fund manager. A fund manager’s mandate is to outperform the relevant market benchmark returns. A good manager creates value for the investors through, what is known as, “Alpha”. Alpha is the excess return that the fund manager generates, over and above, the returns expected by the investor for taking a certain amount of risk.

Disciplined Investing versus trading

Share prices are highly volatile and can affect the emotions of an investor and thus can induce the investors to buy or sell in short time periods. This practise, more often than not, leads the investor to incur losses. Mutual funds, through a variety of mechanisms, encourage investors to invest over a long time horizon to meet a variety of long term investment objectives like retirement planning, children’s education, wealth creation etc.

Historical data shows that, long term buy and hold is the best strategy to create wealth in the long term. Equity mutual funds provide solutions to investors to meet their long term financial goals through capital appreciation. Historical data analysis suggests that, the effect of volatility reduces considerably, with increase in the investment horizon.

Systematic investment plans (SIPs) encourage investors to take advantage of short term volatility and invest in a disciplined manner to meet their long term financial objectives. Many investors fail to build a substantial investment corpus because they are not able to invest in a disciplined way. Savings not invested regularly often gets spent on discretionary lifestyle related expenses.

Through SIPs, you can invest a portion of your monthly savings in a mutual fund scheme for long term capital appreciation. SIPs also help investors take emotions out of the investment process, which is critical to achieving your long term financial objectives. Very often investors get very enthusiastic in bull market conditions, but get nervous in bear markets. It is an established fact that investments made in bear markets help investors get high returns in the long term.

Through SIPs, you can also take advantage of Rupee Cost Averaging by investing irrespective of whether the markets are low or high. This method helps you buy units of a mutual fund scheme, both in rising and falling markets, which will enable you to average out the purchase price of your units, which in turn will enable you to get higher returns on your investments.

Unlike equity shares, mutual funds provides a variety of effective solutions for a wide range of financial needs of retail investors. For example, if you have lump sum funds to invest but you are not sure about the market timing due to volatile conditions, you can invest in a low risk fund, such as liquid fund, and then purchase units of equity fund of your choice through a systematic transfer plan (STP).

This help you average out the cost of purchase like in SIPs, while enabling you to earn higher return on investment (liquid fund returns are usually much higher than savings bank interest). Such a facility is not available in direct equity investing. Similarly, if you have income needs from your mutual fund portfolio, you can draw a fixed or variable amount of funds from your portfolio through systematic withdrawal plans (SWPs). The withdrawals will help you meet your regular income needs while, the balance invested will continue to earn returns. You can also opt for dividend options of mutual fund schemes to get tax free dividends.

Conclusion

Are mutual funds definitely better than investing directly in equity shares? If you have the necessary stock selection and portfolio management skills, you can invest directly in shares through a stock broker. Investing in shares gives you the freedom of selecting the shares you want to buy or sell, while in mutual funds, you will have to depend on the judgement of the portfolio manager. As discussed earlier, the knowledge, experience and judgement of a fund manager, is likely to be much better than that of a typical retail investor. As such, for most of the retail investors, mutual funds are more beneficial for meeting their long term financial goals.