This question is multidimensional, and the answer depends on where the person is in their journey as an investor. The answer is unique to each individual and cannot be generalized. Let us begin with the basics to help understand which is better between stocks vs mutual funds.
Buying a stock is equal to investing in a company and becoming a part-owner, to the extent of shares purchased. The rights of ownership like voting power, right to transfer ownership, dividends, bonus, split, etc., come with the purchase of shares of a company.
In mutual funds, a set of professionals called asset managers manage the pool of money. The investors subscribe to a mutual fund and contribute money. The fund managers invest in shares, bonds, commodities, etc., as per the mutual fund’s objective. The money gets invested into a large base of stocks that fulfil the fund’s investment objective.
Both investing methods (direct stock or through a mutual fund) is acceptable to generate a return on investment. However, as one can imagine, these two are very different in terms of their risk profile. For beginners and investors who do not track shares and the stock market closely, mutual funds are undoubtedly the best way to invest.
Let us understand the offerings of each of these methods to comprehend their difference better.
Diversification through mutual funds
Irrespective of the investment size, investing in mutual funds provide diversification. Even if the investor buys one scheme, the amount gets invested into anywhere between 20 to 40 stocks. Such diversification is almost impossible through direct equity investment with the same amount of investment.
Essential to note that we must not invest in similar schemes across multiple fund houses. For example, to subscribe to large-cap schemes across fund houses will not classify as diversification. Each fund would have invested in a similar set of companies, albeit in different proportions. Still, the exposure is in the same security. That is similar to holding the same share but through multiple brokerage houses.
Mutual funds are less riskier
Investment in mutual funds gets distributed across a relatively large number of shares. When invested directly, the risk is high as there could be a fair bit of concentration.
Flexible investing options through mutual funds
Mutual funds are attractive given the flexibility they offer; some of them listed below:
- Start with a minimal investment
- There is no need to open a Demat/Depository account
- Buying and selling is simple
- Professional asset managers manage money
Cost of a transaction can be higher in mutual funds
An investor has to pay a securities transaction tax at the time of direct purchase. There could be annual charges to maintain a Demat account and brokerage fees.
Mutual Funds, on the other hand, charge management fees. Actively managed funds charge more vs passively managed funds. Exit load may also be applicable in some instances.
Generally speaking, mutual funds may cost higher in terms of total transaction costs. However, do not expect these costs to be significant enough to affect a decision.
Systematic Investing through mutual funds inculcates savings discipline
Through a Systematic Investment Plan (SIP), the investor contributes a fixed amount over time. A SIP helps manage an investment regime over a long period:
- An equal sum gets invested regularly on specific dates
- SIPs apply the concept of cost averaging and delivers the best returns when pursued for a long-term
- Deep understanding of market trends or economics is not required
- Imposes discipline on savings, especially for those with irregular inflows
- Interest/dividend gets reinvested in growth plans providing compounding returns
- Highly liquid
Direct investing is time-consuming
An investor must spend significant time and energy on research to identify an investible opportunity. A fair bit of analytical skills and economic and market understanding are required to spot a stock successfully.
A fund manager manages the portfolio of a Mutual fund. These asset managers are experienced professionals who understand the nitty-gritty of markets and possess sound knowledge to carry out these responsibilities. Investors can rely on fund managers’ ability, and in those ways, a mutual fund allows passive investing.
Several options available when investing through a Mutual fund
Equity funds – Investment happens in equity shares of listed companies. The equity funds are considered suitable for investors with a long-term investment horizon and investors with a moderate risk appetite.
Debt funds – These debt funds invest in fixed income securities such as government bills or corporate deposits. Debt funds are relatively less risky and suitable for investors who wish to barter risk for higher returns.
Hybrid funds – The funds invest in a mix of equity shares and fixed income securities. The idea is to maintain a balance between risk and return.
Some of the other funds are – gold funds, international equities funds, retirement funds etc. While investing directly into stocks, such flexibility is not available.
Direct stock investing is more volatile
Subscribing to a mutual fund means splitting the investment across dozens of securities. Any movement in the value is a reflection of average movement across this large set of shares. On the other hand, investment in stocks would only be in a few for the same investment amount.
Since the mutual fund comprises many shares held together, the returns are less volatile when compared to returns of just a handful of stocks invested directly.
Also, price movement in stocks gets easily highlighted in the case of direct holdings. In contrast, in a mutual fund, the outcome is an average of many stocks’ prices. If there is a massive return on any specific stock, the investor gets tempted to sell and realize the gains. The psychology works in case of a steep fall as well, where the investor would like to get rid of a risky asset. The ability to buy and sell specific stocks leads to churn and thereby increases volatility.
Criteria to invest is the same for a mutual fund or a stock
- Investment horizon (short term or long term) is an essential criterion. Also, the tax liability on the sale of investment depends on the tenure of ownership
- Income requirements – recurring or accumulate gains through reinvesting
- Risk tolerance – volatile returns or consistent returns
- Liquidity requirements – provide for any immediate needs; early withdrawal can be detrimental to overall returns
- Preferences – set goals keeping in mind fondness towards any specific equity or debt
Do read about ‘Top ten benefits of investing in mutual funds‘ here.
What is better between Stocks and Mutual Funds?
Are you still confused? The below table summarizes the pros and cons of investing in stocks vs mutual funds.
Suppose the objective is to minimize risk and the time invested in studying stocks. Also, there is a comfort to incur money management fees for convenience. In that case, mutual funds are a better investment option. On the other hand, if the investor enjoys studying markets and diving into financial research, is a risk-taker, investing directly in stocks may be the better option.
The author is a senior finance professional with over fifteen years of work experience in corporate finance and has an affinity for personal finance and investment management. Please leave your comment or share thoughts on this article via email at firstname.lastname@example.org. For more articles, please visit the website www.decodefinance.in.
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