Mutual Funds vs Direct Equity Investments

Knowing Direct Equity

Direct equity investment can be very rewarding, however, the risk of loss in direct equity is also very high. It is not easy to understand equity. One needs to understand the underlying business and industry the business operates in, before investing in equity (stocks).

This means, you as an investor have to go through the company’s past records, financial performance, management experience, and even external factors such as Government policy, foreign exchange rate, and political changes both domestically and internationally.

If you can balance find the right balance between risk and return, you can reap greater benefits.

Direct Equity vs Mutual Funds

There are various benefits of investing through mutual funds which may not be available if one invests directly through shares.

While direct equity investing provides high returns, it is feasible for those investors who can understand the working of equity markets regularly.

So for those who don’t have the time or skill to monitor equity or share markets, the mutual fund’s route could be better and beneficial.

Some of the advantages of mutual funds are as follows:

• Professional Management

Individuals may not have the necessary skills to identify the right stocks. Not everyone can dedicate time to do research. Mutual funds, therefore, offer investors the expertise of fund managers.

• Low Ticket Size

As some shares quote very high prices, they remain inaccessible for small investors. However, one can start investing in mutual funds which invest in various stocks as low as Rs. 500.

• Fees & Expenses

For their services, mutual funds charge fund management fees and expenses which are capped under the regulation.

If an investor wants to trade in equities he/she need not pay for the DEMAT or trading charges. However, investors should be careful not to buy funds with very high expense ratios.

• Liquidity

Open-ended funds allow investors to exit at the prevailing NAV, subject to exit loads. This helps in financial planning. When an individual invests in shares, he is not sure if he can sell the shares in the market at a fair value or not.

• Risk Management

An individual may go overboard on a particular stock. However, a fund manager will have risk management guidelines in place.

There are limits on how much a fund manager can invest in each stock &  sector. A fund manager’s decision to invest in a particular share is backed by strong research conducted by the fund manager & his/her team members.

• Choice Of Funds

Investors can choose to invest in a scheme that suits their investment needs. For example, an aggressive investor may choose to invest in a diversified equity fund, whereas a less risky investor may opt for a balanced fund.

• Taxation

When an individual investor buys & sells shares before completing the tenure of 1 year, he ends up paying short-term capital gains. However, the fund managers may keep transacting in shares at varying intervals.

If the investor remains invested for more than 1 year in an equity fund, his gains are totally tax-free since STT (Securities Transaction Tax) is already deducted.

A Short Story with Mutual Funds

How can Shashank use the Mutual Fund route to earn more?

Shashank wants to invest Rs. 1,000 in 5 stocks. Since the collective investment in mutual funds would work better, he approaches 5 of his friends – Harish, Lokesh, Manish, Shailesh & Kumar. While the first 3 are keen to invest Rs. 1,000 each, Shailesh & Kumar agree to chip in with Rs. 500. They appoint Santosh as their fund manager.

Santosh collects Rs. 5,000 in total & issues units of Rs. 10 to each of them. This gives Shailesh & Kumar 50 units each whereas others get 100 units. As the fund manager, Santosh buys one stock of each blue-chip stock on January 1.

At the end of the month, the prices of these stocks change & the portfolio value increases to Rs. 5,250.  Santosh charges 1.5% from the returns for his services as a fund manager.

Had the share prices fallen, the valuation of the investments would have fallen as well.

On the other hand, if each of them had separately invested in a blue-chip company (stock) which was around Rs 900. Shailesh and Kumar couldn’t have even participated.

Making a Decision

• Do you Understand Equities?

One of the most important factors to invest in mutual funds and equities is to answer a question – do you understand equities? How to know whether you understand equities better or not? Do you understand the underlying business and how it earns money? Can you figure out the fair value of that business?

If the answer to any of these questions is NO – equity is probably not for you.

• Do You Have Time to Trade and Track Stocks?

Another important factor that you should consider before investing in mutual funds & equities is to answer this important question – do you have time to trade & track stocks?

If you cannot monitor your portfolio and time your exit then your investment may not reap the reward you expect.

• Behavioral Biases

Many individuals start direct investments but lack the discipline to continually allocate time to make investment decisions. If you face similar issues, you should consider investing in mutual funds.

The process is simple. You have to set up a monthly systematic investment plan(SIP) on mutual funds that you think is appropriate for your investment goals.

It is also behaviorally optimal to meet your life goals through mutual funds. Why? Direct investment requires active decision-making — when to buy & sell shares. You can buy shares at a lower price or sell shares at a higher price.

SIP on mutual funds helps you distance yourself from active decision-making. Besides, index funds do not have the risk of underperforming the market, as they are designed to mimic the market.

• Long-term and Diversification

If you want the best of both worlds then you need to invest in the long term. At least for a minimum period of 3-5 years. This can give the desired returns from an investment – be it MFs or stocks.

However, when it comes to stocks, it will be difficult to time your exit while in MFs, you can exit in a certain period.

Another way to go about it is, even if you don’t want to take a risk, invest a small portion of your investment in equities and balance in MFs. That way, you get the benefits of both investment avenues. And your risk is capped as you only have a small exposure to equities.

Companies such as Groww help new investors get started without any hassles.

Disclaimer: This blog is solely for educational purposes. The securities/investments quoted here are not recommendatory.

Mutual fund investments are subject to market risks, read all scheme-related documents carefully.