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Wednesday, September 29, 2010

Are you Investing in Mutual Fund?

While everyone fantasizes about investing in the stock markets and is passionate about investing in stocks, what’s more important is; How smartly are these investments done?

One can invest in the stock markets either through the direct route i.e. stocks or through the indirect route i.e. mutual funds.

Both have their own pros and cons, and so it’s important for you to understand both routes before embarking on an investment spree.

If an investor has a profound insight into stocks and investments with the requisite time and skill to analyze companies, then he can surely begin independent stock-picking. However, if an investor lacks any one or all these pre-requisites, then he’s better off investing in stocks through the indirect route i.e. through mutual funds. Mutual funds offer several important advantages over direct stockpicking.

1. Diversification

Investing in stocks directly has one serious drawback - lack of diversification. By putting your money into just a few stocks, you can subject yourself to considerable risk. Decline in a single stock can have an adverse impact on your investments, damaging the returns of your portfolio.

A mutual fund, by investing in several stocks, tries to overcome the risk of investing in just 3-4 stocks. By holding say, 15 stocks, the fund avoids the danger of one rotten apple spoiling the whole portfolio. Funds own anywhere from a couple of dozen to more than a hundred stocks. A diversified portfolio may thus fall to a lesser extent, even if a few stocks fall dramatically. Also, a mutual fund’s NAV may certainly drop, but mutual funds tend to not fall as freely or as easily as stocks. The legal structure and stringent regulations that bind a mutual fund do a very good job of safeguarding investor interest.

2. Professional management

Active portfolio management requires not only sound investment sense, but also considerable time and skill.

By investing in a mutual fund, you as an investor do not have to track the prospects and potential of the companies in the mutual fund portfolio. This is already being done for you, by skilled research professionals appointed by the mutual fund houses, professionals whose job it is to continuously research and monitor these companies.

3. Lower entry level

There are very few quality stocks today that investors can buy with Rs. 5,000 in hand. This is especially true when valuations are expensive. Sometimes, with as much as Rs 5,000 you can buy just a single stock.

In the case of mutual funds, the minimum investment amount requirement is as low as Rs. 500.

This is especially encouraging for investors who start small and at the same time take exposure to the fund’s portfolio of 20-30 stocks.

4. Economies of scale

By buying a handful of stocks, the stock investors lose out on economies of scale. This directly impacts the profitability of portfolio. If investors buy or sell actively, the impact on profitability would be that much higher.

On the other hand, in case of mutual funds, frequent voluminous purchases/sales results in proportionately lower trading costs than individuals thus translating into significantly better investment performance.

5. Innovative plans/services for investors

By investing in the stock market directly, investors deprive themselves of various innovative plans offered by fund houses.

For example, mutual funds offer automatic re-investment plans, systematic investment plans (SIPs), systematic withdrawal plans (SWPs), asset allocation plans, triggers etc., tools that enable you to efficiently manage your portfolio from a financial planning perspective too.

These features allow you to enter/exit funds, or switch from one fund to another, seamlessly - something that will probably never be possible in case of stocks.

6. Liquidity

A stock investor may not always find the liquidity in a stock to the extent they may want.

There could be days when the stock is hitting an upper/lower circuit, thus curtailing buying/selling. Further, if an investor is invested in a penny stock, he may find it difficult to get out of it.

On the other hand, mutual funds offer some much required liquidity while investing. In case of an open-ended fund, you can buy/sell at that day's NAV by simply approaching the fund house directly, or by approaching your mutual fund distributor or even by transacting online.

As highlighted above, investing in mutual funds has some unique benefits that may not be available to stock investors. However by no means are we insinuating that mutual fund investing is the only way of clocking growth. This can also be done even by investing directly into the right stocks. However, mutual funds offer the investor a relatively safer and surer way of picking growth minus the hassle and stress that has become synonymous with stocks over the years.

On account of the mentioned advantages which mutual funds offer, they (mutual funds) have emerged as immensely popular asset class, especially for retail investor, and for the investor looking for growth with lower risks.