Mutual Funds or Stocks?

Consider the following situation that we are faced with often:

You are considering investing some money through equity mutual funds. You have already invested in Fixed Deposits, Tax Savings instruments and have adequate balance in your savings account for short term emergencies. You have shortlisted select mutual funds based on your desktop research and are ready to take the leap.

But before that you meet a friend/colleague who actively invests in stocks and claims to have a large stock portfolio. He has shared with you the story of Stock X which tripled in 6 months from when he bought it. He’s currently told you about this company Stock Y which is making a revolutionary product that could make this company a potential multi-bagger in just 2-3 years.

What do you do? Should you buy Stock Y? Or stick to your plan and buy mutual funds?

Consider an investing regimen wherein you invest in mutual funds largely and take selective exposure to stocks as you develop your skills as an investor, grow your corpus and are able to do the necessary grunt work required for stock selection.

The answer may lie in thinking along the following lines.

Do you have a fair idea of and trust your friend’s investment strategy and his track record? 

It will be useful to understand how your friend/colleague zeroed in on this particular investment idea. For example, WhatsApp groups where members dish out stock tips are fairly commonplace. I would stray away from your colleague’s advice if it’s based just on a secret source that may not even be kosher.

Secondly, how has his portfolio of stocks performed in the past? I would be worried if it comprises just one or two stocks that have delivered attractive returns.

And finally, it’s your money and if you are going to follow someone’s investment advice, wouldn’t you rather trust a professional fund manager with years of investing experience and a demonstrated performance track record?

Are you comfortable with the risks involved with investing directly into equities?

It’s fairly common for individual stocks to be more impacted by downturns than the indices they are part of.  Hypothetically, if you invested in the Nifty 50 on 29^th-Jan-15, you would have lost 17% of your investment if you sold on 27-Jan-16. Similarly, if you invested in Hindustan Unilever (HLL), this loss should be around 18%. The volatility of returns of an investment in the Nifty 50, HLL or HDFC ltd are 1.0%, 1.5% and 1.8% respectively for this period and higher volatility implies higher risk. This just indicates the higher volatility inherent in direct equity investments. By the way, we love HDFC and HLL as much as anyone else and want to showcase the risk of investing in even the best quality individual stocks. While the reverse is also true, in bullish markets (upward trending), riskier stocks may deliver better returns than the index but then that would require us to know whether the markets will move up or down.

The chart below shows the rebased movement (assuming all start at 1) of Nifty 50, HLL and HDFC Ltd for a 1 year period where the Nifty 50 has corrected.

Mutual funds offer you an opportunity to invest in a diversified basket of stocks that are benchmarked to and track the performance of a pre-defined index such as the Nifty50. This diversification helps by partially addressing this volatility in direct equity investments. In a nutshell, mutual funds offer an investments choice that is less risky than concentrated stock bets.

Do you have the time to do the necessary research and build your own investment hypothesis around stocks?

Selecting an individual stock normally requires an understanding of the sector, market cycles, and fundamentals of the company and a host of other factors that professional stock pickers may take years to master. And you would need to do this evaluation for each stock that you plan to invest in. For most of us working professionals, it is a challenge to devote the required time and effort to build conviction around a particular stock. Wouldn’t you rather spend that time with your family, or chase that promotion at work?

In conclusion, a studied approach to investing will bode well for each of us in the long term. Keep in mind that mutual funds vs equities is not a binary decision. Consider an investing regimen wherein you invest in mutual funds largely and take selective exposure to stocks as you develop your skills as an investor, grow your corpus and are able to do the necessary grunt work required for stock selection.

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