Before diving deep in this analysis let me share with you one incident of my life which happened around 5 years back.
One of my friends who settled back in India after a long professional journey of around 20 years in different European countries came to my house to stay with my family for few days. During the general conversation, discussions on adulterated foods and cultivation through pesticides & chemical fertilizers started. With great enthusiasm, he unveiled “I cultivate my food grains and vegetables by my own without using any artificial pesticides and fertilizer. I bought an agricultural land and converted it in a decent farm house.”
“I produce all possible crops and vegetables like wheat, rice, pulses, mustard, barley and all seasonal vegetables of my choice in my farm house. I nurture it carefully right from selection of healthy seed, Proper fertilization, weeding till harvesting and proper storage of the food produced. Alongside, I have also kept a lot of good breed cows and sell their milk to the dairy companies and use organic fertilizer made from cow dung in my field.”
The narrative that my friend established has created a thought process in my mind with few apprehensions. I started analyzing the pros and cons of this tale like What if, despite proper care, the crop gets destroyed due to some accidental or natural reason or if it does not yield enough. Is it possible for a common man to grow his food by himself? Does a common man have such specialized knowledge and resources? Mostly we all bring the groceries and vegetables from the market.
Being finance professional, I found it very similar to investments in financial instruments like stocks and mutual funds. Growing your food materials by yourself is good enough to get the pure and healthy food but it requires a lot of specialized knowledge, regular attention, hard work, time and patience. Simultaneously, capacity to bear losses in case of a natural calamity is a must for this process. Similarly investing directly in stocks is like growing your own food by yourself. In this process whatever you grow, you have to eat it.
When you invest through mutual funds, it is like buying food articles of your choice from market of your preference without making any specialized efforts. It may keep you relaxed from many complexities involved in growing your food by yourself which is like investing in stocks directly.
Mutual funds and shares, both investment options offer great returns but many of us remain mystified in process of choosing our investment preferences. It is because the investment instruments offered by both the investment routes are misunderstood by the people in general.
What are Mutual Funds?
Mutual funds are like a basket having collection of stocks, bonds and securities that are managed by professional fund managers. Investors purchase the units of mutual fund schemes of their choice. This is how; mutual fund creates a pool of money invested by the investors. Equity mutual fund contains stocks, while debt mutual funds have government bonds and other debt securities. Fund managers of the mutual fund further invest this pooled corpus in diversified financial instruments as per the scheme specifications.
Fund manager takes all the investment decision on behalf of investors to get the best returns on investment. The profit earned by the scheme is shared among the unit holders in a proportionate manner.
What are Stocks/Shares?
Stocks are financial instruments issued by companies to raise money. It gives Investors a proportionate ownership in a company. When a company goes public and issues shares, an investor can buy these shares through stock exchange and become the shareholder of that company. Investment in shares is made for capital appreciation, dividends, and also for voting rights, which allows them to be a part of key company decisions. As the market value of the company rises, earnings of the shareholders rise and vice versa. Stocks are also known as shares and as equities.
Mutual Fund investment Vs Direct investment in stocks – Key differences:
Before analyzing, which investment is better for which category of investor, it is important to understand what are the key differences in between the two investment options:
- Mutual Fund investments are considered as a safe investment as compared to the direct investment in shares. If you invest in share of a company, you may either earn a high profit or you may have to face a capital loss. Mutual fund offers diversified portfolio to the investors. This reduces the risk on investment with reasonable earning prospects. Every investor can easily have a diversified portfolio through mutual fund investment. This diversification cannot be attained by a small investor in direct stock investment. Simultaneously, creating a diversified portfolio is a task possible only with a specialized exposure in stock market.
- Mutual Fund offers some tax benefit to its investors. Investments made in Equity Linked savings Scheme (ELSS) are exempted from tax up to 1.5 lakhs under Section 80C. Whereas the profit earned (Capital Gain) on shares is a taxable income.
- Buying units of a mutual fund scheme does not give any kind of ownership in the company whereas investing in the shares of a particular company gives you proportionate ownership of a company.
- In mutual fund your investments are managed by the fund managers who take all the investment decisions on behalf of the investors. Investor cannot influence the decision of fund managers regarding selection of stocks. In direct stocks investment, investor can choose the stock of his choice but thorough knowledge, good exposure of share market, economy and financial products is a must for the investor to get good returns.
- Mutual fund investment is supposed to be a passive investment. Role of investor is limited to selection of mutual fund scheme and investment / redemption timings only. Remaining fund management activities are done by the fund managers. Therefore, it is called passive investment. Investment in shares needs active participation of the investors in process to manage their investment portfolio.
- Demat account is a must for trading (buying or selling shares) in the share market which is not necessary for mutual fund investments (except ELSS).
- Mutual fund investment offers a disciplined investment opportunity through Systematic investment plan (SIP) which gives the benefit of averaging also. While investing in shares, such investment on fixed periodic interval is not an easy task because the stock prices fluctuate constantly and need personal attention and prompt trade decision.
- Investing in a mutual fund involves some charges like fund management charges, Exit load etc. In share market investment, investors only need to pay the brokerage to the stoke broker. At the same time, if the investment/redemption in mutual funds is done on direct mode without any involvement of a distributor, there is no brokerage applicable.
- Stock prices fluctuate very frequently. Investment returns in direct stock investment may be higher than the mutual funds investment returns but it is not possible for every investor to earn high through direct stock investment. Probability of loss is also very high with such investments. In mutual funds, returns may be a little less than the stock investment but chance of losses is less as compared to direct stock investment. The reason being the mutual funds are managed by seasoned professional fund managers.
Mutual Fund investment Vs Direct investment in stocks – Comparison at a glance
|Parameters||Mutual Fund Investments||Direct Stock Investment|
|Risk involved||Less Risky||Highly Risky|
|Tax exemption||Available with ELSS||No similar tax exemption|
|Portfolio Diversification||Yes||Difficult if the corpus is small.|
|Fund management||By professional fund managers||By investor himself|
|Passive or active investment||Passive investment Active investment||Active investment|
|Demat requirement||Required only for ELSS||Required|
|Investment discipline like SIP||Yes||Optional but difficult for investor to manage|
|Loads and expenses||As per scheme specification. No brokerage if transacted on direct mode.||Only brokerage is payable|
|Returns||Depends on market conditions, Choice of scheme and time horizon||Depends on market conditions, Choice of shares and time horizon|
For which investor category, Mutual Fund is a better investment option:
- The investor who is new and inexperienced should always prefer mutual fund investments.
- The investors who don’t have capacity to bear the volatility of the stock market should invest in mutual funds.
- The investor looking for diversified portfolio should invest in mutual funds.
- The investors who don’t have time and skill to manage their investment portfolio should invest in mutual funds. It is because the investment made by you is managed by a team of experts whose intent is to give you consistent returns over the long term.
- The investment made to fulfill a future financial goal should be in a suitable mutual fund scheme. Mutual funds give you a wide variety of investment options in line of your future financial goals within the stipulated time period. It is good to start with mutual funds before entering in stock investments.
- The investors who recently started their career and wanted to create wealth through systematic investment on periodical basis must invest in mutual funds through SIP.
- The investors investing for a specific purpose like education of their children, buying own house, retirement planning etc. should prefer investing in mutual funds choosing suitable schemes.
For which investors, direct stock investment is a better investment option
A seasoned investor, who has the time and expertise to understand the undercurrent of the stock market, ability to analyze the financial statements and future prospects of companies, having strong control over the emotional and psychological biases and ability to bear losses should invest directly in stocks. Such investors should have ability to create their own portfolio of stocks. They can earn superlative returns associated with stock investing in comparison to a normal investor.