Before we get into comparing mutual funds, stocks and then planning your investment and executing it, it is important for you to understand what mutual funds are, how they work, what you get and what you don’t get out of it. There are 2-3 dozen good mutual funds out there, and you will have to choose few from them, so it is important that you understand which ones are good, how they generate returns for you and how much returns can they generate for you.
- 1 What Are Mutual Funds ?
- 2 Major Benefits And Drawbacks Of Mutual Fund Investment
- 3 A Comparison Between Stocks And Mutual Funds
- 3.1 One Needs A Lot Of Time To Research Stocks But Not Mutual Funds
- 3.2 Mutual Funds Offer More Diversification Than Stocks
- 3.3 Stocks Offer More Return Than Mutual Funds But Are Risky
- 3.4 Mutual Funds Have More Costs Compared To Stocks
- 3.5 Mutual Funds Offer Tax Benefits
- 3.6 Difficult To Invest Through SIP In Stocks
- 4 How To Start Investing In Mutual Funds
- 5 Case Study On Mutual Fund Investment
What Are Mutual Funds ?
Think of mutual funds as a collection of multiple shares and you get to own a part of that company. It’s the same bread example like shares but here think of a tutti frutti bread (the frutti part signifies each slice having a piece of different company). So when you buy 10 units of a mutual fund, you actually buy a “piece of share” of almost 60-80 companies.
Let me explain this with a very simple example. Take a look at this mutual fund page on moneycontrol : Kotak Select Focus Fund
The NAV of this fund is 34 (as of 16 April 2018). So when you invest Rs. 500 into this mutual fund, you get 14.7 units. Now click the portfolio section and see the holdings of this fund house. When you buy 14.7 units, you are buying a small part of each of those companies.
Notice how I am not saying a share but a piece. You cannot buy a share of each of those companies for Rs. 500 only. But through mutual fund you get to buy a small piece (let’s say 1/10th of a share) of each company.
To understand how this works, you will have to study how mutual funds work.
A mutual fund is a company which takes money from hundreds (or even thousands) of investors, pools them together and then invests in the stock market. Retail investors (common people with 9-5 job) don’t really have money to diversify a lot (buy few shares of many companies which is safer than investing in few companies), but if 10-20 investors had to pool their money, they would have a lot of money and hence can diversify.
This pooling is what is done in a mutual fund. The fund company has a fund manager and few other people who advise him on stocks. This company collects a lot of money from investors and buys stocks. What the investors get in return are units of that company which appreciates or depreciates in value according to the value of the investment.
So if the fund company has bought shares from 60-70 companies and has invested Rs. 100 crores, then if the current value of the investment goes above Rs. 100 crore then the unit value (NAV) goes up and vice-versa. The company of-course keeps changing the portfolio (adding good shares and removing those which they think might under-perform) but your allotted units remain same.
Just like any other company, a mutual fund company too has some expenses (employee salary) and profits. So what they do is take a cut from your returns when you exit. When you study about basic analysis of mutual funds in next post you will come across a term called entry and exit load. So for eg. when you invest Rs. 5000 you might have to pay Rs. 100 to the company and when you exit (with gains or loss) you will pay another Rs. 100-200. The entry and exit loads are percent based and might be nil for some companies.
Mutual funds are usually classified under two categories :
Types Of Mutual Fund By Structure
a) Open Ended Funds – These are type of mutual funds which you can buy and sell anytime you want to. So taking the same example of Kotak fund, you can buy it anytime and exit anytime you want to as it is open ended.
b) Closed Ended Funds – These are type of funds which are available for buying for few weeks only. So if you want to buy them you will only get 4-5 weeks from their launch time and when that period is over, you cannot buy or invest more.
Types Of Mutual Fund By Holdings
a) Equity Funds – Mutual funds which invest money in stock market. They are known for high annual returns but do carry a risk. These are further classified as :
Large Cap Funds – Mutual funds which invest more money in companies with market capitalization of more than Rs. 20,000 Crore.
Mid Cap Funds – Funds which invest a large portion of their money in companies with market capital of Rs. 5,000 Cr. to 20,000 Cr.
Small Cap Funds – Funds which invest more money in companies with market capital less than Rs. 5000 cr.
Thematic Funds – Each and every stock company belongs to a sector (Auto, telecom, pharma etc.). Thematic funds are those mutual funds which invest money in only one sector or theme.
ELSS – These are also known as tax saving funds. If you want to save taxes (upto Rs. 1.5 lakhs per year) you can invest in these funds. Please note that all ELSS have a lock-in period of 3 years which means you cannot take your money out from ELSS fund for atleast 3 years once you have made an entry.
b) Debt Funds – These mutual funds invest their money in bonds of reputed companies and governments. They are very safe (not 100% but still safer than equity) and generate lesser returns as compared to equity funds.
c) Balanced Funds – Mutual funds which invest money in both equity and debt, much more safer than equity funds and give more return than debt funds.
d) Index Funds – Funds which invest their money in companies which form Nifty in same weightage. So if Nifty consists of 50 companies and each company has 1%-5% weight then the index fund will invest in same 50 companies and distribute money according to their weightage in Nifty index.
e) Liquid Funds – Funds which invest money in government treasury bills. People usually use them for parking their money for a short period of time and get some returns.
There is something else that you must know. Some of the mutual funds have Growth and Dividend in their name. You need to understand the difference between the two as it can make a lot of difference in your investment.
Mutual funds which have dividend in their name, usually pay dividend to their customers in their bank accounts. So if a fund has invested Rs. 100 Cr. in 40-50 companies and receives Rs. 50 lakhs as dividend then it will have to distribute this dividend among the shareholders depending on their holding quantity.
Those mutual funds which have growth in their title re-invest your dividend in the same fund. So if you were supposed to receive Rs. 50 as dividend, then instead of depositing that money in your bank account, the fund house will re-invest that amount in the same fund under your name. So you might get an extra unit or two of that fund (depending on the amount of dividend).
Over a period of time this re-investment does make a significant difference and hence growth oriented mutual funds are preferred by common people.
Major Benefits And Drawbacks Of Mutual Fund Investment
Before I mention the benefits and drawbacks let me just say that this section is meant to clear your doubts about investment and not scare you about losses.
Benefits Of Mutual Funds
1) Diversification In Stocks : Usually in a stock market the more stocks you buy the more safe you are from experiencing losses. Even if half your stocks go down, other half will go up and atleast you won’t make much losses. Now it is not that easy to buy shares of a hundred company and add them to your portfolio. Plus you will have to track all those companies and make decisions regarding adding more, holding or selling.
2) Affordability : Mutual funds don’t really cost that much. There are so many funds that you can buy for Rs. 500 only. Of-course there will be some 1%-2% charges but still they don’t really cost that much. And the main point here is access to diversification for a mere Rs. 500. You can buy few stocks for Rs. 500 too but you will be buying maybe one share from 4-5 companies each. Not much diversification compared to mutual funds.
3) Professional Management : There are so many retail investors who don’t understand much about stock markets or equity investment (or anything other than savings). Making decisions regarding management of your portfolio is difficult if you don’t have a financial adviser by your side. This is where mutual funds come into picture. They offer professional management for a fee. They make the decisions regarding buying and selling of stocks. The more you make, obviously the more they get because when you exit they get 1%-2% of your entire stake.
4) Goal Driven Investment : There are hundreds, if not thousands, of mutual funds operating out there. You can choose anyone as per your requirements. If you need to save for retirement then a large cap equity diversified fund will be good for you. If you want to create a lot of wealth in short term then a mid cap fund will do you good. If you want to plan retirement, need funds within next few years and want to save taxes just invest in 3 funds which combined can give you all the benefits.
5) Tax Saving Opportunities : This one remains one of my favorites. Go through any ELSS mutual funds (or majority of them) and you will see a performance comparable to any other mutual fund with good returns. Add the benefit of saving income tax and this is golden. So in a nutshell you just have to invest Rs. 1,50,000 every year (or a monthly SIP of Rs. 10,000-11,000) and this will keep growing till you exit (of-course the returns from ELSS are taxable under LTCG and also have a 3 year lock-in period).
6) Easier To Understand : Trust me on this one, beginners are often asked to invest more in mutual funds and not directly in stocks (unless they have a good salary) because investment requires a lot of reading, analyzing and control of emotions. While stocks are very tricky to master, mutual funds are relatively easy and good for those who want to get started with equity investment.
Drawbacks Of Mutual Funds
1) Entry And Exit Costs : Mutual funds usually have both entry and exit load. This means you pay a small fee every-time you buy a fund and when you sell it and exit (in case of both gains and losses). This could be bothersome for those who can manage their own portfolio. This load usually means that you invest less then your intended amount (by 1% or entry load) and you get less than your real return (by another 1% or exit load).
2) Lesser Returns : Although mutual funds return more than fixed deposits or bonds (government or private) they still return less than stocks. I personally don’t have much experience but you can safely generate 25%-30% through direct stock investment (check past 10 year returns of Nifty stocks) as compared to 12%-15% of mutual funds. Over a period of let’s say 10 years this small difference can affect your returns by a lot.
3) Lock-In Period : Some of the mutual funds have a lock-in period. What that means is that once entered you cannot exit from that fund. So if you have any emergency you won’t be able to withdraw those funds. Be careful about such lock-in periods. Almost all ELSS funds have a lock-in period of 3 years.
4) Cash Reserve Policy : Most of the mutual funds save a lot of cash to pay those who want to exit. This helps them in situations where all of sudden many people want to exit. This is a wastage of cash and hence affects the overall returns of that fund. That cash could have been invested in the market for more returns.
5) No Control : You don’t get to decide when to buy stocks, when to sell, how much to buy etc. So even if you notice that something shouldn’t have been done you can’t really do much. But then if you understand that much maybe mutual funds are not for you.
6) Big AUM Or Size : All the mutual funds have some money to invest. When this amount increases in size then it becomes difficult to manage it. And more the amount, lesser the returns. It is easy to grow Rs. 100 Cr. at 30% per year but not that easy to grow Rs. 10,000 Cr. at 30%. There just aren’t that many investment opportunities out there.
Even though there are quite a few disadvantages listed above please don’t get scared because almost in no condition are you losing money (except when the market starts crashing or is in bear phase). So do participate in equity investments through mutual funds or shares.
A Comparison Between Stocks And Mutual Funds
Given both the options for investment which one would you go for? I have mentioned some points below which will help you understand both stocks and mutual funds and help you make better decisions.
One Needs A Lot Of Time To Research Stocks But Not Mutual Funds
You will have to read a lot and invest a lot of time if you want to invest directly in stocks. You need to read for like 3-4 hrs. daily to understand the fundamentals of each company before you decide to invest in that company.I myself have experience of only 2 years and still haven’t learnt a lot (not enough to be an independent decision maker). I still read other people’s opinion on Telegram groups and other forums to see what they have to say about a particular stock (and have paid prices for following other people’s opinion).
When you have a 9-5 job (I work from home but still don’t get much time) you come back home by 6-7 and then will want to rest. There are hardly few people who would want to go through the details of the stock market, plan and develop a strategy and then follow through it (and also monitor the performance of that strategy). This makes investment in stocks a risky affair for people like us.
This is why mutual funds are a preferred way of investing in equity. While you do need to read and build a strategy, it will hardly take a month of reading (daily 1-2 hrs.) and you will be able to reap the benefits of equity investment. Of-course in either case (stocks and funds) it would be difficult to predict market movement but it is easy to choose 3 funds over let’s say 10 stocks and while stocks can go down by 30% and make you panic, funds will go down by 10%-15% and you won’t lose your senses.
Mutual Funds Offer More Diversification Than Stocks
This one is obvious. A mutual fund company invests in atleast 50-60 companies because they pool investor’s wealth. It is very hard (almost impossible) to invest money in 60 companies manually and track them all together. Stock movements are wild compared to mutual funds. If you had to see all your stocks go down by 20-30% you will lose your mind and book loss.
Of-course with diversity you get safety. When market becomes volatile, mutual funds go down by 2% (or maybe more) but stocks can correct by 8%-10%. This is because mutual funds hold 5-6 dozen companies and not all companies go down. Some do go up and this balances the overall loss. But if invest in stocks and are holding 10-12 stocks, your whole portfolio will become red and you will start panicking. Also no one knows when the market will go down (or up) so it is difficult to keep cash ready to average your positions.
Stocks Offer More Return Than Mutual Funds But Are Risky
In the world of equity investment (or business) we use a phrase called Risk To Return ratio. What this means is that there is an inherent risk that comes along with every investment decision. No one can give you “assured”, “guaranteed” or “no-risk guarantee) returns in the market.
If you invest xyz amount of money there is a chance that you might lose all or some part of that investment. Business do fail, governments do collapse, nations go bankrupt and banks can collapse. Trust me it is very difficult for any person to say that you can “safely put your money” somewhere and get guarantee returns. Even governments fail to offer 100% guarantee.
Mutual funds do offer more safety than stocks because of diversification but they offer lower returns. If you lose 10%-15% within a year due to economy slowdown or some other condition which affects the market, then you gain 10%-15% a year through mutual funds.
With stocks it is the same situation. When the market corrects or turns volatile, you can lose 30% of your portfolio within few days (whether you actually lose everything or not depends on you exiting from the market) but then stocks can give you 30% return in a year too. So you risk losing 30% or more and you can get a return of 30% or more. Of-course there are some funds which can give you that much too, but I was just trying to explain a concept. Take the case of HEG – this company gave 1000% return within a year (10 times your investment in a year).
This is how you analyze the risk and return of a specific instrument. House is important because should you lose all your investment (gold, money, stocks, land etc.) you will have a place to go to. Of-course houses can collapse in an earthquake but still what are the chances. And hence you say that a house is a must because even though there is a risk associated with it, you still think that it is safe. Your attitude should be the same with stocks and mutual funds.
Mutual Funds Have More Costs Compared To Stocks
To buy a mutual fund you pay some fee (known as entry load) and then there is the exit load (pay a fee when you want to exit). Then there is the recurring management cost (another 1%-2%) per year which goes from your pocket (or returns). Now if you think about it people do make enough returns and most of them hardly care about it. But still it should be mentioned for your own benefit (who knows whether you would like it or not).
Stocks don’t really cost that much. Of-course in mutual funds someone else manages your investment and hence it is only fair to pay them a fee but still if you have time in your hands, why not study, do your own research and manage your own stock portfolio? In the market every penny saved is a penny made. When you save the costs, you can invest them and generate more returns from the market.
Stocks usually have brokerage charges and nothing much more. So people who have a lot of time or can dedicate weekends to studying about stock markets can opt for direct stock investments.
Mutual Funds Offer Tax Benefits
As mentioned above some of the mutual funds (also known as ELSS) offer tax benefits upto Rs. 1.5 lakh. This means you can just invest Rs. 1.5 lakhs from your annual salary and claim it as deduction under Section 80C. Stocks don’t offer this benefit and in the long run I would personally advise beginners to save tax and invest that money as that way you get best of both the worlds. You get to save tax and invest that in equity segment.
*Please note that ELSS have a 3 year lock-in period which means you can’t take your money out from them for 3 years once invested.
Difficult To Invest Through SIP In Stocks
Most of the people are salaried class. They have a job, make some money, save some and invest some. This means that they have maybe Rs. 2000 or 3000 to invest every month in stocks (or anywhere) (also known as Systematic Investment Plan).
Not only is it difficult to research about stocks, it is hard enough to say for sure if you can keep investing in a stock for a year or two. Let’s say you choose 10 stocks and initially invest Rs. 500 in each. Then you keep buying for 10 months, and from that point 3 of the stocks correct by 30%. You averaged that stock till top and it fell down and now you don’t know if it will come up again or not.
This situation is avoidable in mutual funds. You just keep buying units as long as you want to invest in that fund. You can exit anytime. Of-course mutual funds go down too, but the chances of them recovering are way more than stocks. They can easily sell under-performing stocks and buy new stocks and the NAV can come up again without you losing any money. It’s not the same with stocks.
So SIP is easier with mutual funds.
How To Start Investing In Mutual Funds
It is not very difficult to start investing in mutual funds. You just have to choose the online service that you want to use, open an account and start investing. Most of the online services offer netbanking services so you can just “shop” for mutual funds through them. I am listing 3 popular methods of buying mutual funds online.
Investing Through Zerodha
Zerodha offers a service called Zerodha Coin. You just need to open an account with Zerodha (open an account here : Zerodha). You can then transfer whatever amount you want to and then go to coin.zerodha.com and then search for all the listed mutual funds. It will show you that particular fund and then you can place your order. Please make sure you have done your research and have gone through the terms of investment (entry and exit load, lock-in period etc.)
Pros : You can use Zerodha for trading and investing in stocks too. This gives you the best of both the worlds in equity segment. Also selling your holding and transferring your money to your bank account is a breeze.
Cons : You will be charged a flat fee of Rs. 50 per month (Rs. 600 per year) no matter how many mutual funds you buy or sell. Your total investment should be more than Rs. 25,000 though for this fee to apply. This loss of Rs. 600 would be a turn off for some people but then majority want to invest in stocks so they prefer this.
Investing Through Fundsindia
Fundsindia is also an online investment service. I actually got started with online fund investment through Fundsindia and then switched to Zerodha for other benefits. Fundsindia service is also nice and buying and selling is a breeze.
Pros : Not much over Zerodha. You do pay a fee of Rs. 200 + service tax every year. But it is still less than Zerodha. You can check the details of their fee structure here : Fundsindia Fee. Also you can setup SIP through your bank account on Fundsindia, which is kind of hard to do in Zerodha Coin. Just setup multiple SIPs and your bank account will be deducted for that much amount on a fixed date which will be invested in your chosen fund.
Cons : Although you can invest in stocks through Fundsindia, you won’t have access to NSE stocks. Only companies listed on BSE are allowed on it. So you should use it for only mutual fund investment and not stock investment.
Investing Directly In Mutual Funds
You can also check out these companies for direct mutual fund purchases : Karvy and CAMS. You won’t have to pay any brokerage fee or maintenance fee or anything else. Just create an account, get e-verified and start investing through SIP or lumpsum. This might sound good but if fee is your concern, then give Fundsindia a serious thought. They don’t charge that much fee.
Personally I have invested Rs. 90,000 through Fundsindia and Rs. 1,30,000 through Zerodha in Axis Long Term fund (ELSS or tax saving). I used to invest monthly through Fundsindia (and have recommended few friends too) so I know it is a good platform.
Also note that all mutual fund purchases or redemption happen at the end of the day. This is called settlement. Every time you place an order through Zerodha Coin or Fundsindia, if that order was placed before 3:30 then the order will be executed at the end of day at that day’s NAV. If you place an order after market closes, then the mutual fund will be bought at next day’s NAV. Same thing happens with redemption too. When you sell your mutual fund then depending on your fund, it might take 1-3 days for it to be sold.
If you want to sell at that day’s NAV then sell it before 3:30 otherwise it will be sold at next day’s NAV (which is calculated after market closes).
Case Study On Mutual Fund Investment
This section has been created just to enlighten you about how much difference investing in equity can make in your life. I have included details about all sort of investments that you can do and their past performance and an insight into future results (*past performance is just an indicator and does not guarantee similar returns in future).
No Investment And Only Savings
Savings are good, atleast compared to spending mindlessly. But it does not grow, not like an investment. Let me demonstrate with the help of an example :
A person earning Rs. 20,000 a month saves Rs. 5,000 a month and puts it in his bank account. Bank accounts give you a measly 3-4% return every year. That means you save Rs. 60,000 a year and earn Rs. 2400 as return every year. Now of-course you are earning something and every penny makes a difference. But after 10 years of savings you will only have Rs. 830,000. It will be difficult to buy a home for yourself with this money let alone go on a world tour. Even things like LIC and pension schemes won’t do much for you if you want to move to a bigger house.
Investing In Fixed Deposits
Fixed deposits are kind of good. They give you 6-6.5% returns every year and that extra 2% can make a significant difference over 10 years. Assuming above savings you will have saved Rs. 970,000 within 10 years of time, assuming you had been re-investing all your returns every year. This money still cannot help you do much. You might be able to arrange for down-payment of a loan but still you need to save a lot more.
Of-course over a period of let’s say 20 years, you could save Rs. 27 lakhs but the cost of the house would have also increased by a lot and maybe you would be able to manage paying the down-payment only. Please note that maybe your payment will also keep increasing and that has not been considered so you could possible save more but we are just talking about different investment opportunities.
Investing In Real Estate
It is kind of difficult to invest Rs. 5,000 every month in real estate (atleast I cannot think of anything). You need atleast Rs. 80,000-1 lakh to invest in land (or maybe Rs. 40,000-50,000). No one knows how much return you will get out of it. It depends on a lot of factors and luck too. If the government decides to develop a mall or a smart city near that plot of land you could make a lot of profit otherwise you might make 8%-10% or worse case scenario, you could lose everything.
Real estate is something that is not advised to beginners for this exact purpose. No surety of returns. Atleast with savings, bank deposits and mutual funds you do get some surety from so many investors (usually surety means how many people are willing to risk their credibility while backing some investment opportunity, minus the scammers).
And even if that land had to turn out to be a gold mine (which depends on factors like city, location, proximity to railway stations etc.), there is again no surety that your future investment in land will generate same returns for you.
Investing In Gold
Gold has given a return of 13% every year for past 15 years. This makes it an acceptable investment asset. If you had to invest Rs. 5000 every month in gold, within 10 years you would have saved Rs. 14 lakhs which is quite good. You can manage a lot of things with this kind of money. Over a period of 20 years you would have saved Rs. 60 lakhs.
Now we are talking. You can just deposit this amount of Rs. 60 lakhs in a bank and earn Rs. 3.6 lakhs a year as return while your money will just sit there doing nothing. This calculation does not include inflation (rate at which things get costlier so please do that too). I will explain that later in other posts on how to plan your investments.
Investing In Equity
Equity investment is the best asset among all available options. Of-course if you compare past 15 years data the return rate is slightly better than gold. But if you manage your portfolio yourself you can certainly do a lot better.
Let’s start with mutual funds. You can get 12%-15% from large cap mutual funds and 20%-25% from a midcap fund so you can get an average of 17-18%. At 17% growth every year you will be saving Rs. 18 lakhs in 10 years and Rs. 1 Crore in 20 years. Imagine sitting on Rs. 1 crore cash 20 years from now.
With stocks it is even better. You can manage 20%-25% growth every year which means Rs. 25 lakhs in 10 years from now, and Rs. 2 crores in 20 years from now.
Please note that I am not trying to paint a rosy picture of a very bright future which lies ahead if you start investing in equities. You can keep some exposure to all forms of investment for diversity an safety.
Invest money depending on your goals and current situation. I have Rs. 10 lakhs to invest so I am sticking with equity segment because I need financial freedom within 10 years from now.
You need to plan your investment depending on your goals. Now of-course anyone can have a goal but you need to be realistic. With a saving of Rs. 3,000-5,000 a month diversification is little difficult. It can be done, it’s just difficult. But still you can invest Rs. 1,500-Rs. 2,500 in both gold and equity. You could end up saving Rs. 12-15 lakhs within 10 years. Now if you have bigger goals then you will have to put more in equity and divide between stocks and mutual funds.
So Rs. 1000 in gold, Rs. 2,000 in mutual funds and Rs. 2,000 in stocks. This way you could end up saving Rs. 22 lakhs within 10 years.
The more you can save and invest the more you can earn. It is that compounding of extra bit of money in equities that just skyrocketed your savings by 10 lakhs. Imagine if you could invest Rs. 10,000 a month in equity.
You should do all these calculations yourself too using this tool to understand how compounding works : Compound interest calculator
*I have assumed above that you will have some starting amount to invest (Rs. 24,000 in first box) and then Rs. 24,000 every year at 17% for 10 years in case of mutual funds. You can make changes and do calculations and plan your investments.