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Friday, November 19, 2010

Investing In Stocks Versus Mutual Funds

You are a savvy investor. You read a lot about personal finance and investing, and therefore you know very well that equities give the best long term, inflation beating returns among all asset classes.

You need to save for some long term financial goals, and obviously, stocks are your first choice. You decide to invest in a disciplined manner to achieve your goal. So, you open a depository account, a trading account, and start investing in stocks.

The question is - Is this approach correct? Should one invest directly in stocks, or take the help of experts?

Well, the answer would vary from person to person. So, let us compare the two methods of equity investment, to help you find your own answer.

Factor 1 - Time

Many small investors "invest" in stocks for the short term based on tips and rumours, and that is the most inappropriate "investment" strategy. This is trading, and this methodology can suit only traders. They are the ones who invest huge capital and trade with large positions, such that even a 5 paise increase in a stock's price is very profitable for them. But for small investors, it is a losing battle.

Investment in shares should be done only for the long term, keeping in mind the soundness of the company's strategies and management. Investment in stocks, therefore, needs a lot of research. It involves fundamental analysis - a study of the fundamental factors that affect the performance of a company. These factors may include the industry in which the company operates, growth rate of the industry, domestic and international competition, overall economic scenario (interest rates, inflation, exchange rate, etc), and so on.

This research needs to be done not just before choosing a stock, but even for its continuous tracking during the entire holding period. This kind of research needs a heavy investment of time. Do you, as a small investor, have this kind of time to spare?

Factor 2 - Expertise

Researching a company requires a thorough knowledge of valuation and accounting principles, and interpretation of various financial ratios like RoE, RoCE, RoNW, etc. It would also require access to latest financial results and other financial information about companies.

Fundamental research would also require knowledge of the industry in which the company operates.

Do you have such access and expertise?

Factor 3 - Transaction Costs

As a small, individual investor, your transaction volumes would be very modest. This also means that most of the brokers would charge you the highest brokerage - remember, at most brokerages, the brokerage cost as a percentage of trade value decreases as your trade volumes increase.

This transaction cost has a direct and significant impact on your ultimate returns.

Are you prepared for this?

Factor 4 - Reaction Speed

If there is a sudden change in economic factors, and it changes some of the fundamental factors affecting the company, would you be able to think in a dispassionate, level-headed manner.

Would you be able to act fast and react?

Factor 5 - Control Over Investment

How important is "control" to you?

Do you want to decide how much is invested where? Or you can trust an external expert for your investments?

These are some of the factors that would help you in deciding whether to invest directly in the stock markets, or through mutual funds (MFs).

If we consider the profile of a typical small investor, he would have a full time job, and would be investing only to achieve his financial goals. He would not be an expert in valuation and accounting. He would also not have the time to research companies thoroughly.

So, as a general principle, it is advisable for small investors to invest half of their equity investments through mutual funds and for rest of the sum, get stock analysts and experts advise to invest directly in stocks.

After a due course of time, you can evaluate your returns on your mutual fund as well as stocks comparing it with index like Nifty and Sensex. Your selection of mutual fund scheme and  stock experts for direct investment in stocks would be correct only if your investments outperform major indices over a period of 3-5 years.