Knowing these rules will save you from taking undue risks, losses and also create wealth in the long run, says Dwaipayan Bose.
Illustration: Dominic Xavier/Rediff.com
Some investors may think that since mutual funds invest in stocks they are better off investing in stocks directly through a broker, instead of investing in mutual funds.
Some people cite fund expense ratios and lack of control over the investments as key reasons why stocks score over mutual funds.
However, in our view, mutual funds, is a much better investment option for retail investors, since the benefits of investing in mutual funds far outweigh the costs.
Let us discuss the 7 key benefits of investing in mutual funds versus directly in shares.
Before, we discuss the advantages of mutual funds, let us explain for the benefit of investors, how mutual funds work.
What are mutual funds?
Mutual fund is a financial instrument which pools the money of different people and invests them in stocks, bonds etc.
Each investor in a mutual fund scheme owns units of the fund, which represents a portion of the holdings of the scheme.
The securities are selected keeping in mind the investment objective of the scheme. Mutual funds are managed by asset management companies (AMCs).
AMCs appoint fund managers to manage different mutual fund schemes and ensure that the scheme investment objectives are met.
For fund management and other services provided by AMCs, they charge a fee to the investors. These expenses are charged proportionately against the assets of the fund and are adjusted in the price of the unit.
Let us now discuss the major advantages of investing in mutual funds versus directly in stocks.
1. Risk diversification
The biggest advantage of investing in mutual funds versus stocks is risk diversification.
Every stock is subject to three types of risk: company risk, sector risk and market risk.
Company risk and sector risk are unsystematic risks, while market risk is known as systematic risk.
What is the essential difference between unsystematic and systematic risk?
The stock price of a company may fall if the company's financial performance is poor, even if the market rises.
On the other hand, even if the company performs well, the stock price may still fall, if the market falls.
Mutual funds help investors diversify unsystematic risks by investing in a diversified portfolio of stocks across different sectors.
Hence, mutual fund risk is much lower than individual stocks.
2. Smaller capital outlay
Investors require a large capital outlay to build a diversified portfolio of stocks.
On the other hand, since mutual funds work on the basis of pooling of money, mutual fund investors can have the beneficial ownership of a diversified portfolio of stocks with a much smaller capital outlay.
Investors can buy units of a diversified equity fund with an investment as low as Rs 5,000 only (or even lower for some schemes).
3. Investment expertise
Investing in stock market requires a lot of experience and expertise.
In our view understanding the risk return trade-offs in stock market investments is the most important part of equity investing.
Many retail investors have lost money in share trading because they make poor risk return trade-offs.
Mutual funds are managed by professional fund managers who have sufficient expertise and experience in picking the right stocks to get the best risk adjusted returns.
4. Economies of scale in transaction costs
Since mutual funds buy and sell securities in large volumes, transaction costs on a per unit basis is much lower than what retail investors may incur if they buy or sell shares through stock brokers.
5. Variety of products
Mutual funds offer investors a variety of products to suit their risk profiles and investment objectives.
Apart from equity funds, there are also balanced funds, monthly income plans, income funds and liquid funds to suit different investment requirements.
6. Variety of modes of investments
Mutual funds also offer investors flexibility in terms of modes of investment and withdrawal.
Investors can opt for different investment modes like lump sum (or one time), systematic investment plans, systematic transfer plans (from other mutual fund schemes), systematic withdrawal plans, switches from one scheme to another etc.
You can invest in growth option of mutual funds if you want to take advantage of compounded returns over a long investment period.
You can invest in dividend option if you want regular income from your investment.
No other investment product offers such wide array of investment modes.
7. Disciplined investing
Share prices are highly volatile and can induce the investor to buy or sell in short time periods due to fear or greed.
Frequent trading often leads the investor to incur losses. Mutual funds encourage investors to invest over a long time horizon, which is essential to creating wealth.
Furthermore, systematic investment plans encourage investors to 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.
Systematic investment plans (SIPs) in mutual funds help investors to maintain a disciplined approach to savings and investment.
SIPs also help investors take emotions out of the investment process.
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.
By investing through SIPs in a mechanical way, investors can stay disciplined, which is critical to achieving their financial objectives.
In this article we have discussed the key benefits of investing in mutual funds versus directly investing in shares.
While investing directly in shares may give you a greater sense of control, the benefits of investing in mutual funds outweigh that of investing directly in shares.
If you have expertise in picking stocks and are able to devote a lot of time attending annual general meetings, dial in to results conference calls, reading and analysing balance sheets and income statements, you can invest directly in shares.
In reality, vast majority of retail investors neither have the expertise nor can they devote sufficient time to this.
For retail investors, therefore, investing in mutual fund is definitely a much better option than investing in stocks.