Investment Choices: Mutual Funds or Individual Stocks - Which Proves More Profitable?
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Is it smarter for new investors to invest in stocks or mutual funds? Allow me to shed some light on this question, so you can make an informed decision when you're ready to park your hard-earned cash into the stock market to achieve your financial goals or create long-term wealth.
Stocks, Mutual Funds, and Their Basics
Let's begin by understanding the nuts and bolts of these investment options.
Stocks are financial instruments given by companies to investors, granting them a stake in the company. The main purpose for investors to sink their surplus funds into stocks is capital growth, dividends, and voting rights, which allow them to have a say in key company decisions. Stocks are often referred to as shares or equities.
On the other hand, mutual funds are financial vehicles where multiple investors' money is combined and invested in various asset classes like equities, bonds, or gold, depending on the fund's investment objectives.
Mutual funds provide professional fund management skills and numerous fund choices. There are three main categories of funds: Equity funds, Debt funds, and Hybrid funds. Additionally, there are solution-oriented funds such as retirement and children's funds, along with other variations like index funds, exchange-traded funds, and Fund of Funds options.
Stocks or Mutual Funds: Which is the Better Option?
While both options give you a chance to invest in equities, let me walk you through the top seven reasons why you should consider mutual funds over direct stock investments.
1. Portfolio Diversification
Due to mutual funds' ability to invest in a vast universe of stocks, portfolio diversification is superior. Most diversified funds on the market have 50 stocks or more in their portfolios.
Diversification helps limit losses when a single stock or two gets negatively impacted. Moreover, equity funds limit the exposure to each stock to just 10%, minimizing the risk in investments. On the flip side, an individual investor's portfolio typically contains 10 to 15 stocks, leading to a higher level of volatility.
If you aspire for the same diversification level as a mutual fund, you'll need substantial money. Moreover, there are costs associated with buying and selling, such as brokerage, STT, SEBI turnover charges, GST, transaction charges, and more.
The beauty of mutual funds is that even investing a small sum of just Rs. 500 exposes you to a vast pool of stocks across various market capitalizations and sectors.
2. Professional Management
Mutual funds are expertly managed by professional teams that conduct thorough research on stocks, sectors, and the economy. They meticulously analyze a company's financial statements, interact with management, and employ robust risk management processes, which prevents them from taking undue risks.
In contrast, stock investors must put in a considerable amount of time researching stocks, multiple sectors, and the broader economy to have a solid perspective.
3. Cost Effectiveness
Mutual funds benefit from cost savings due to the vast transaction volumes involved in the purchasing and selling of stocks. The introduction of direct plans for the mutual fund industry by SEBI in 2013 also led to a lower expense ratio for investors.
Consider the Kotak Flexicap Fund, which has an expense ratio of 1.49% in the regular plan and 0.64% in the direct plan. This 0.85% difference translates into higher returns for the investor. Over the long run, this difference can accumulate to several lakhs of rupees.
When it comes to stock investments, there are fees such as brokerage, STT, SEBI turnover charges, GST, transaction charges, and more. However, these expenses are minimal in the long run, given that frequent trading is not a common activity.
4. Variety of Options
Mutual funds offer numerous choices to help achieve your financial goals since they cater to different asset classes like equities, bonds, and international equities. They also have solution-oriented funds like retirement and children's plans, as well as active and passive funds.
This wide range of options lets you decide on the choices that best suit your risk profile and time horizon. For instance, if you are a risk-averse investor, you can choose debt funds with limited exposure to large-cap equities. On the other hand, aggressive investors can invest in all market capitalizations and various sectors.
Stock investing offers only one asset class, and although it may seem there are thousands of companies to choose from, there are usually only a few hundred that are investable. The broad array of options available in mutual funds, including specific categories or funds to achieve goals, diversification, and debt exposure, is not available when investing directly in stocks.
5. Investment Discipline
Mutual funds encourage a disciplined approach to investing, as seen with Systematic Investment Plans (SIPs) that enable regular investment into mutual funds from as low as Rs. 500.
Although some brokerages offer SIPs for buying stocks, the importance lies in making the right stock selection, and the investment amount can fluctuate based on the stock prices.
6. Tax Efficiency (in certain types)
While the taxation of equity mutual funds and stocks is uniform, Equity Linked Savings Schemes (ELSS), a type of mutual fund scheme, can be claimed as a deduction under section 80C, up to Rs. 1.5 Lakh annually. This tax benefit is not available for stock investments.
Additionally, the fund manager's stock movement does not result in tax implications for investors. In contrast, taxes must be paid when exiting an individual stock investment based on the holding period.
7. Return Variability
Due to mutual funds' portfolio diversification, the risk is mitigated, enabling consistent returns across periods. Although individual stocks have the potential to yield exceptional returns, mutual funds are subject to fewer restrictions and are highly diversified, which cap their return potential. This is why stocks are often preferred by High Net Worth Individuals (HNIs) and Ultra High Net Worth Individuals (UHNIs). However, this approach might not be suitable for novice investors.
The Final Verdict
If you are a seasoned investor with the time and expertise to analyze financial statements and have a knack for research, you may consider building your own stock portfolio. The extraordinary returns associated with stock investments come with a fair share of volatility, so proceed with caution.
Famed investor John Bogle, the father of index funds, once said, "If you find it hard to imagine a 20% loss in the stock markets, you shouldn’t be in stocks."
On the other hand, if you're comfortable with your funds being overseen by a team of experts whose primary objective is to deliver consistent returns over the long term, then mutual funds are your best bet. Mutual funds present a wealth of choices to meet your goals and achieve them with greater consistency. Thus, if you're a first-time investor who hasn't yet ventured into the capital market, starting with mutual funds before stepping into the stock market is a wise move.
- For new investors, mutual funds can be an excellent choice for long-term wealth creation, offering various asset classes such as equity funds, debt funds, and hybrid funds, which are professionally managed to deliver consistent returns.
- When compared to direct stock investments, mutual funds provide numerous benefits, including portfolio diversification, cost-effectiveness, and a wide range of options, ensuring investments that align with individual risk profiles and time horizons.
- Mutual funds also foster investment discipline through schemes like Systematic Investment Plans (SIPs), which enable regular, low-cost investing.
- In terms of tax efficiency, Equity Linked Savings Schemes (ELSS) mutual funds offer tax deductions under section 80C, and fund managers' stock movements do not result in tax implications for investors.
- While stocks have the potential for extraordinary returns, the volatility they present can be risky for novice investors, emphasizing the importance of making informed decisions when it comes to personal-finance and finance strategies.
