May 9, 2009

Direct Stock Investing vs Mutual Funds: How to Decide?

The most common dilemma faced by first time investors is whether to go for direct stock investing or route through mutual funds. Which one is a smarter investment strategy? Unfortunately, there’s no easy answer to this question because there are so many factors involved. Let’s try to understand pro and cons of each investment style:

Direct Stock Investing vs. Mutual Funds: A Comparison

Mutual Funds offer several advantages over direct stock picking. Here are few benefits of mutual funds investing:

PROS of mutual fund investing:

1. Professionally-managed portfolio
Mutual funds are managed by professionals who take investment decisions based on thorough economy, industry and company research rather than ad-hoc decisions based on market tips and broker’s advice. Besides, they keep a regular watch even after investing. Thus, mutual funds are an easy way to take advantage of professional expertise at an affordable price.


2. In-built Diversification
Top-most benefit of investing in mutual funds is built-in diversification. Mutual funds offer convenient and effective way to achieve instant diversification.

Although you can achieve the objective of diversification through direct investing also but for that you require quite huge amount of money. On the other hand, you can do the same through mutual funds by making a single investment of just a few bucks.

For example, suppose you are having Rs 10,000 to invest. If you invest directly in stocks, how many numbers of different stocks can you buy? One or may be two. Now, if you go for a mutual fund, let’s say, diversified equity mutual fund, you get exposure to 40-60 stocks just by investing a very small amount.

In short, mutual funds allow you the benefit of diversification without investing large sums of money that would be required to create an individual portfolio.

Why do you need to diversify? Because, diversification reduces risk by spreading your investments among various companies belonging to different industries. A downturn of a company/sector gets offset by the better performance of other companies/sectors.


3. Transparency
Mutual fund industry is regulated by SEBI & AMFI. Gradually, over a period of time, the investment practices have more become more transparent due to stringent regulations regarding manner of investments, maximum exposure limits, expense ratio’s, entry & exit loads, manner of calculating and disclosing NAVs. Thus, it is safer to invest in mutual funds. Chances of getting duped are minimal.


CONS of Mutual Fund Investing

But there is other side of the coin too. You should also know that there are certain demerits associated with mutual fund investing:

1. Too Bulky Portfolios
Holding too many stocks in a portfolio can lead to unnecessary duplication and sub-optimal performance. This is particularly relevant to over-sized funds investing in small and mid-caps. Due to high illiquidity in small and mid-cap segments, a mutual fund can not take large exposures.

The problem with too big portfolio’s (over-diversification) is that rather than out performing the market, portfolio simply mimics the market returns which in turns defeats the very purpose of active investing.


2. Too much churning of portfolios
In the over-enthusiasm to outperform their index counterparts, a lot many fund managers indulge in frequent churning of portfolios which amounts to timing the markets and shows a lack of long term approach. Also, it doesn’t ordinarily result in higher returns due to high brokerage and other costs.


3. Rampant mis-selling
While investing in mutual funds, you rely on the advice of so-called advisors who are just agents/ distributors of financial products with half-baked knowledge and more interested in earning their commissions rather than keeping the investor’s interest in mind. For further details check out: Myths about Mutual Fund Investing.


4. Herd Mentality
Portfolio of most funds in the same category (funds with similar objective) is more or less the same?

In the words of Peter Lynch, (Excerpts from his book “
LEARN to EARN: A Beginner’s Guide to the Basics of Investing and Business”)

“…herd of fund managers tend to graze in the same pasture of stocks. They feel comfortable buying the same stocks the other managers are buying and they avoid wandering off into unfamiliar territory. So they miss the exciting prospects that can be found outside the boundaries of the herd”.

But why? There are two basic reasons behind it. First is called herd instinct (the comfort of going with the crowds is powerfully attractive because to humans a group offers security) and second is that underperformance of fund managers can be treated quite harshly.

Because mandate given to fund managers is to beat the benchmark index, fear of underperformance drives them towards mediocre performance by conforming to the peers and invest mostly in benchmark index securities rather than taking risks by surfing in unchartered waters. If a fund manager holds the same ICICI, ACC or DLF’s and they drop, the economy can be blamed. However, if they show more creativity with stock picking, the onus will fall directly on them.

If you invest directly you are in a privileged position as compared to fund managers because unlike them you are not answerable to anybody and therefore need not chase returns. Furthermore, what’s more important to you is real absolute returns and not the relative outperformance.


5. Paradox of Choice
One argument against direct investing is that retail investor has neither the time nor the expertise required to research and pick individual stocks. But this multitude of choice also exists in mutual fund space. There are thousands of mutual fund schemes available in the market. At present, around 30 fund houses with more than 2000 schemes are present in India. If you want to invest in mutual funds, say, equity diversified schemes; you’ll have to research over 200 schemes. Even if you leave aside the recently launched funds and concentrate only on funds with a long term performance, there are more than 100 diversified equity schemes with a track record of more than 5 years.

However, unlike direct stock picking, there is a way out – to remove the clutter – as rating of mutual fund schemes is periodically done and published by VALUE RESEARCH, Economic Times and Outlook Money.


To sum up, invest directly if you have the requisite time and skill to do proper & thorough research and also keep a regular vigil on your investments. On the other hand, if you are too busy in your work and can’t spare time or don’t have the inclination towards stock markets, it is better to hand over your money to mutual funds. It’s an easy and convenient way to invest.

Anyhow, whether you want to rely on your own wisdom or on the wisdom of so-called specialist, the choice is yours. However, if you decide in favor of mutual fund investing, please keep in mind the following Smart principles of mutual fund investing.

And if you decide to take a direct plunge into the markets which requires a lot of patience and discipline, remember to start small, learn some basic investment principles, be wary of human irrationality and flaws in our decision making and don’t forget to do regular portfolio rebalancing. I’ll be covering the direct stock investing principles and decisions flaws in my future posts. In the meantime, you can put your own views in the comment box.



Also see:

1. Top 5 Stock Investing Pitfalls
2. Investing in Gold ETFs - FAQs
3. PPF vs NSC - Which is better?
4. How to Select the Best Equity Funds?

3 comments:

  1. which is the best equity mf

    ReplyDelete
  2. Your question is very simple. Well, the answer is far from simple and straightforward. I’ll have to write another post to answer it. So, wait for sometime.

    ReplyDelete
  3. Fisher .... please write a post answering the above comment as you promised !!

    ReplyDelete

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