Hazards of investing directly in stocks


It hurts less when your MF holdings fall 10% compared with a similar decline in stock assets

The sharp increase in asset prices since March last has made many wonder whether investing directly in the stock market is better than buying mutual funds. In this article, we discuss why mutual funds are preferable for goal-based investments.

Beyond diversification

We are not going to argue that diversification is the important reason to choose mutual funds. Just because a fund holds 30-40 stocks does not mean it is diversified. It is the relationship that these securities have with each other in the portfolio that will determine whether the fund is truly diversified or not. You have no way of knowing the constituents of the portfolio, leave alone how they were created; equity funds disclose their holdings only once every month as per SEBI guidelines. Our arguments are, therefore, based on operational efficiency and behavioural factors.

Consider operational efficiency. Your day job could make it difficult for you to track the market on a continual basis. By this, we mean keeping an eye on corporate developments and macroeconomic variables, all of which drive stock prices. And even if you are able to do this, how will you decide how many stocks to buy for your portfolio?

This leads to behavioural aspect of investing. You may have hand-picked 20 stocks for your portfolio. And then some of the stocks that you excluded from your portfolio may outperform the ones you invested in. So, the regret from missing out on the prominent ones (in hindsight) will subtract the happiness that you experience because of the positive returns you earn on the investments you made. And there is more.

Moderating regret

It hurts less when your mutual fund investment declines 10% compared to your direct investment losing the same value! Why? You outsource your investment decision to a professional money manager when you invest in a mutual fund. So, you can blame the money manager if the fund performs poorly. Of course, your chances of achieving your goals will be affected whether the loss is because of mutual fund investments or direct investments. Nevertheless, outsourcing the decision helps alleviate regret.

But choosing a mutual fund is also a decision that could lead to regret, you may argue. True, but only if you invest in active funds — funds that expect to beat their benchmark indices. Such funds have to actively choose stocks to create portfolios. So, returns may vary across funds within the same category (say large-cap funds). Indeed, your regret would be high if the fund you invested in is not within the five best performing funds in that category.

You could, therefore, buy index funds. All large-cap index funds would be benchmarked to either the NSE 50 Index or the BSE Sensex. The difference in their return is a function of how much cash they hold to meet redemption requests and the fees they charge to manage the fund. Both these factors are stable. So, you can simply pick an index fund with the lowest tracking error.

Conclusion

There are other benefits of investing in mutual funds. For one, your initial investment can be as low as ₹5,000. You cannot buy a lot of shares with that money in today’s market. For another, managing your investment is easier because you have just one fund to consider — not 20 or 25 stocks as in the case of direct investing. That said, the dominating factor favouring mutual funds over direct investment is the behavioural aspect to your investment decision.

A caveat is in order. Luck plays a dominant role in investment success. And this factor is more evident when you make direct investments. Also, your level of happiness is relative to your peers. So, if you compare yourself to a colleague or friend who made direct investments and became rich, you are likely to regret — even if you invest in index funds.

(The writer offers training programmes for individuals to manage their personal investments)

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