Mutual funds vs Direct stocks: Which one is right for you?

Stocks are more lucrative than mutual funds if you can pull it off. But make no mistake, they can be far riskier and call for extensive research, especially if you are a novice investor.

Mutual funds vs Direct stocks Which one is right for you

A particular scene in the Tom Hanks-Meg Ryan starrer You’ve Got Mail should appeal to the investor in you: an elderly woman named Birdie, an employee at a neighbourhood bookstore, cheekily tells her employer, “I’m very rich, I bought Intel at 6.”

The movie does not reveal how much money Birdie made from investing in a tech giant when presumably it was small. But for the sake of academic interest, let us try.

If we assume the scene played out in 1998 – the year of the film’s release – it would mean Birdie’s investment in Intel Corp had more than tripled in value by then, because as per the stock’s history, it had hit $20 that year.

So if she had bought a thousand shares, her investment of $6000 (at $6 a share) would be worth $20,000 at the time she made her boast. 

The thought of an elderly woman making money on shares may cause you to shake your head in wonderment, but don’t get carried away. In real life, not everyone can claim to have Birdie’s insight (or luck?) in spotting a winner among a raft of new stocks. Or even old ones, for that matter.

What makes investing in stocks attractive?

Equities are complex and need extensive research, especially if you are a novice. But make no mistake, investing in stocks has its attractions:

Wealth creation: Seasoned investors are drawn to equities because they have the potential for high capital appreciation and high returns; in other words, stocks can create wealth, as in Birdie’s case.

In the Indian context, let us consider the Sensex, the index of the Bombay Stock Exchange (BSE), to study wealth creation. The compound annual growth rate (CAGR) of the Sensex, a percentage figure that reflects the returns on investments in its listed scrips over a period of time, has been a healthy 15.71%, 11%, and 10.96% over the last 5, 10, and 15 years respectively, going back to 2007.

If you are wondering how ‘healthy’ these returns are, if at all, compare the numbers with that of government-backed debt savings schemes (say, provident funds) since 2007; returns here have stayed in the 8.25%-9.5% range annually. Clearly, the latter yield less.

Quick returns: If you choose the right stocks and sell them at the right time, you can expect quick and good returns; but for this you need to have very good knowledge of the stock market, so it’s easier said than done.

Beats Inflation: By earning high returns, your investments in equities can beat inflation. 

High liquidity: This means stocks can be turned into cash (i.e. sold) quickly; the stock market allows you to do this at any time – such as when money is needed urgently. Transaction costs are not high either (NSE charges a transaction fee of 0.00325% of the total value of shares sold/bought, while BSE charges 0.00275%).

Loan facility: If you don’t want to sell but need money at short notice, you can pledge your shares with a bank for a loan, and get up to 50% of the share value.

Tax benefits: Investments in equities are not tax-free, but there are tax benefits; income from the sale of your stock attracts both long-term and short-term capital gains (LTCG and STCG) taxes. However, income up to Rs 1 lakh from equity investments is tax-exempt, though LTCG is imposed at 10% without the benefit of indexation for amounts over that (if your holding period exceeds one year); STCG is at 15%. Incidentally, returns on debt or gold investments invite higher tax obligations than equities.

Part ownership: By buying shares, you are investing in a company and get part ownership. You are therefore entitled to a share of its income in the form of dividends. (This sort of income suits investors with a long-term horizon). If you are lucky, there may be rights shares and bonus shares in store – i.e. more dividends.

Low maintenance: Stocks involve no annual or recurrent fees except for demat account charges, Securities Transaction Tax (STT), and transaction charges if any.

Related: How to turn stock market volatility into an investment opportunity?

What makes stocks look less attractive?

To repeat, equities are complex and have their downsides, as listed below:

High risk: Investing in stocks is riskier than mutual funds (we will dwell on this later). If a company does poorly, the price of its stock falls. In other words, your holding loses value.

Diversification pressure: Diversification is the most crucial aspect of investing, as a well-diversified portfolio cuts down the risk factor considerably. But to reach that stage by directly investing in stocks, an investor should own at least 25-30 stocks. How many small or rookie investors can afford that? At the most, they probably will have 5-10 individual stocks (sometimes only 2-3). This is simply inadequate.

Time-intensive: It is not enough to cut through the clutter of sectors, industries, and companies to choose a suitable stock; you also have to research and follow each individual stock, plus track and understand the economic and political developments at home and abroad that can impact it. All this is immensely time-consuming. 

Emotionally draining: Taken together, the above factors can be very taxing mentally. In fact, investors are not only overwhelmed by high losses but by high returns as well. Consequently, they sometimes take rash decisions. They may even get too ‘attached’ to the stocks they have chosen, and refuse to sell even if those tank.

What makes mutual funds so attractive?

Equity mutual funds are ideal for those whose exposure to the world of investment is limited. Such people tend to have little idea of the right stock to invest in, due to lack of time or knowledge. Let us see how they can benefit from mutual funds:

Professional management: This feature of mutual funds is its single-most attraction for rookie investors and those pressed for time. Mutual funds pool the investments of a large number of individual investors, and this pool is managed by professional fund managers. This means individual investors do not need to figure out which stock to invest in; it will be done by financial experts. This eliminates the tension, and you save on time.

Easy diversification: It is easier for a fund investor to practise diversification than an individual investor, especially a rookie, because each fund owns small pieces of many investments, cutting across sectors and asset types. In fact, many fixed income asset types (such as bonds) are not available to individual investors. And because of this diversification, price movements of individual stocks have only a limited impact on the investment as a whole.

Time saving: With direct investing in stocks, you are the active player, but with mutual funds, it is the opposite: you sit back while a fund manager invests their time and expertise to manage your portfolio. This is convenient for people with full-time jobs.

SIP facility: Mutual funds offer Systematic Investment Plans (SIPs), through which you can invest some part of your monthly income. This helps to build a savings and investing habit, and is ideal for individuals who wish to invest a fixed amount each month on a given date. Read more about stock SIPs?

Tax savings: Stocks sold by mutual funds attract no tax on capital gains, which is a substantial benefit. In fact, certain mutual fund schemes have tax-saving benefits; for instance, with ELSS (equity-linked savings schemes), investment up to Rs 1.5 lakh is eligible for tax deduction under Section 80C of the IT Act. Dividends are completely tax-free if the securities are held for more than one year.

Easy liquidity: Mutual funds can be easily liquidated, with most open-ended schemes providing liquidation within three working days. 

Related: Different types of funds available under mutual funds

What makes mutual funds less attractive?

Few things in life come without hiccups. Despite all their advantages, mutual funds too have their share of irritants, though slight. Let’s see what they are:

Not free: The service of the professional fund manager managing your investment is not free; the fund house charges a yearly management fee called the annual expense ratio. Naturally, dabbling in stocks directly involves no fees.

No control: You have no say in the choice of stocks or its duration; the fund manager decides the make-up of your portfolio. This means you are forced to stay invested in a company you might not approve of.

Delayed returns: There are no quick returns with mutual funds, which have a long-term growth trajectory and need at least 5-7 years to generate good returns.

Related: Ditch the ‘milestone mentality’ to grow your wealth

How have stocks performed in the recent past?

The Indian stock markets yo-yoed in 2020, with March seeing the worst ever monthly sell-off since October 2008, but the year ended on a record high.

The 2008 crisis was triggered by the onset of the global financial crisis; on this latest occasion, the sell-off was triggered by the global spread of the COVID-19 pandemic. Indian shareholders lost Rs 3.3 trillion in just one month.

However, the markets started picking up over the following months on the back of multiple bailout packages the government announced, with the Sensex wiping off the year’s losses by November, and the price-to-earnings (P/E) ratio of the Nifty 50 reaching an all-time high of 37.84 on December 18.

The P/E ratio of a stock reflects the amount investors pay for every rupee it earned over the previous 12 months. If that ratio of the Nifty 50 showed an upward curve, it meant the share prices of the companies listed on that index rose faster than their earnings. This was true for other indices as well.

The government’s liquidity support aside, Mukesh Ambani’s Reliance Industries also drove the domestic benchmarks higher in 2020, thanks to deals with multiple high-profile investors such as Google, Facebook, and the Public Investment Fund of Saudi Arabia.

With pessimism having given way to optimism, many analysts now foresee an economic recovery after the second wave of the pandemic blows over. But there are some who fear that the Indian markets will not be soaring ahead in 2021, mostly because domestic stocks have been overvalued for quite some time.

How did mutual funds perform in the recent past?

As equity markets bounced back in the last one year, it rubbed off on equity mutual fund schemes as well, with 19 schemes yielding returns of over 100%. The highest of these was Quant Small Cap Fund (returns of 168%), followed by ICICI Prudential Technology Fund (142%) and ICICI Prudential Commodities Fund (138%). See how to choose an equity mutual fund

Alongside, 392 equity mutual fund schemes that are at least a year old delivered returns of 69% on average. The sectors that shone the most were technology and small-caps.

Related: Here’s how you can invest in mutual funds for different goals

Last words

To sum up, mutual funds, which are SEBI-regulated investment securities, can be a better fit for you if you are a beginner, as compared to directly investing in stocks.

Mutual funds take less of everything – time, effort, experience, and specialised knowledge – to give good returns over an extended period of time. They also involve less risk because of their diversified investment portfolio.

Stocks can also yield good returns, that too quicker than equity mutual funds, but only if you have in-depth knowledge of the financial markets and can buy and sell the right stock at the right time.

If you lack the insight, you can be confused by the bewildering array of sectors, industries, and companies. The roller-coaster ride the stock market went through in 2020 highlights why direct investing in stocks may be beyond the capacity of rookie investors. Equity Mutual Funds vs Stocks: Where to invest?

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