Stocks or mutual funds: which one is better?

For any kind of a long-term investment (and we’ll also define long-term soon), the risk-reward ratio is heavily in favour of equity investments. All arguments for the primacy of ‘risk-free’ fixed income investments fall apart when one realises that what looks like freedom from risk is actually freedom to become poor. This conclusion is unavoidable when you look at real, inflation-adjusted, post-tax returns.

Having accepted the inevitability of equity, one is immediately confronted with the question of how to go about this reportedly difficult activity. For people who have never invested in stocks, it’s hard to know where to make a start.

However, there are two distinct ways of investing in equity. One is to choose stocks for yourself and buy and sell them yourself. And two, invest through equity funds. The final goal is the nominally identical — to benefit from the superior returns that equity investing offers. However, the two activities are completely different. Unless you are an expert, or are willing to spend considerable effort in becoming one, it doesn't make sense to invest yourself —funds are the right choice.

Mind you, I’m not saying that an individual can’t do this. There are many people who manage to invest themselves with considerable success. However, the odds are against any one individual being able to do so, 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 learned to be successful after many failures. That’s something that turns out be a dealbreaker for most who set out to become expert equity investors.

Investing through equity-backed mutual funds sidesteps all these problems neatly. The heart of equity investing is having a correct mental model of how successful stock investing is done, and then having the capacity in terms of information, analysis and execution to execute that. I’m not suggesting, even for a moment, that an individual acting alone can’t do that. What the individual would almost always lack is the capacity, in terms of money and effort, to do this.

But there are many more 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. These could have 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 five 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. And so on and so forth.

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.

Another advantage is that of being able to invest with small amounts. 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. It’s all much more convenient too.

On top of all this, there’s 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 may mean a tax liability. However, in an equity mutual fund, this trading is done by the fund manager inside 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.

That’s a long and, I hope, persuasive list, and if you are not convinced, you can still go ahead and invest in stocks directly. Perhaps you will be among the small minority who succeed.

(The writer is Founder and CEO at Value Research)