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Should you go for stocks or mutual funds?

Stocks or mutual funds? Most of the reasons point one way, but some people's instincts point the other

Should you go for stocks or mutual funds?

Now that my previous pieces have (hopefully) convinced you that most of your your long-term money must be in equity, the question to be tackled is how one should do this. Let's look at this problem step by step. If you have just realised the inevitability of equity, you are immediately confronted with the arguably difficult task of actually investing in equity. For those who have never done this, it's hard to know how to make a beginning.

However, anyone knows there are two distinct ways of investing in equity. One is to choose stocks and buy and sell them yourself. And the other is to invest through equity funds. The final goal is the same, to benefit from the superior returns that equity investing offers. However, in terms of what you do, the two routes are completely different.

Unless you are an expert investor, or are able to put in the (considerable) time and effort in becoming an expert, it does not make sense to invest in equities directly. Therefore, for every beginner--without exception--the choice is quite straightforward: you must invest through mutual funds. I am not saying that an individual can't be successful by investing directly. There are many investors who invest themselves with superior results, and Value Research itself has a premium Stock Advisor service that helps people do just that. However, for any given person, the odds are unfavourable in the sense that for every 100 who try, perhaps 5 or 10 will be successful. An even bigger problem is that even those few would have probably started tasting success after many failures, and each of these failures would have landed them with some losses. For most of us, whose goal is to simply get higher returns for our savings, this business of learning through losses is often a dealbreaker.

Equity-based mutual funds solve all these problems quite simply. There are many advantages to investing in equity through mutual funds. A major one is a disciplined diversification. Fund managers operate within an institutional framework which enforces certain ground rules of investing. For instance, these could be a set of rules defining the investments such as there must be at least 15 or 20 stocks with no less than X per cent of the total portfolio. The stocks must be spread over at least 5 sectors with no sector being less than Y per cent. At least Z per cent must be held only in large companies because they tend to be more stable in bad times. Taken together, such rules define a framework which ensures that the portfolio stays diversified and safe from shocks that may strike individual stocks, sectors or types of stocks. Individuals who manage their own stock investing would rarely have the knowledge or the discipline to do all this.

Being able to start investing in small and flexible chunks is another big advantage. If you try to build a diversified portfolio with stocks by buying them directly, you'll need a relatively large sum of money--at least a few lakhs to begin with. In mutual funds, you can start off by owning the same with a few thousand rupees. You can invest regularly and automatically with a fixed amount every month, and you can actually save tax under section 80C by investing up to Rs 1.5 lakh a year in designated equity mutual funds.

On top of all this, there is one advantage that results in higher, in the long term, much higher, returns in equity mutual funds. All equity portfolios need some buying or selling as individual stocks become more or less desirable. If you are trading stocks yourself then these transactions will mean a tax liability. However, in an equity mutual fund, this trading is done by the fund manager managing the fund. You don't have a tax liability because you haven't made transactions yourselves. There's a further multiplier to the tax saved because the money stays available as an investment and thus gains even more. For long term investments that compound over years, this can make a huge difference.

Taken together, this should be a persuasive list of reasons to prefer equity mutual funds over equity. Of course, if you are not convinced, you can still go ahead and invest in stocks directly. It'll be a tougher task, but you could well be among those who find success.