To really answer this question completely, one will need to write a whole book. But for me, the challenge is to wrap this topic within this blog post. Hence I’ll try to be as direct as possible.
To decide between shares or mutual funds as to which vehicle is better, we must first understand who asks the question. If the inquisitors are like Warren Buffett, Peter Lynch, Charlie Munger, Joel Greenblatt, John Bogle, and Bill Ackman, undoubtedly, shares will be better. But if the people in consideration are like you and me, perhaps mutual funds is the choice.
But this is not the final answer. It is just a generalization. I’ll explain the pick between shares or mutual funds in more detail. Then you can decide your preference.
It is logical for beginners to get confused between picking shares and mutual funds as their preferred investment option. But many eventually opt for mutual funds as everyone else around them is investing in them. Moreover, people also hear that investing in shares is risky.
But ultimately, everything in investment boils down to these two things – ‘potential returns‘ and ‘risk of loss.’ If the person knows how to manage the risks associated with an investment, then good returns will happen as a byproduct.
The big risk associated with stock investing is about picking stocks of fundamentally weak or overvalued companies. People who know how to negate this risk can invest in stocks. But otherwise, Mutual Funds will be a safer alternative.
A similar risk is also associated while investing in equity-based mutual funds. But this risk is managed by the mutual fund manager. It is not the responsibility of the investor. Hence, people who do not know how to analyze stocks should stick with mutual funds.
Shares or Mutual Funds – Investment Process Comparison
People who like the concept of passive investing, shares would look too asking to them. For such people, the mutual fund will be more suitable. Why? Because the time required to research stocks before picking one for investment is a time-taking activity. Comparatively, mutual funds can be picked in a jiffy.
Let’s try to understand it through the back-drop of the process of investing. Generally speaking, there are four stages of an investment process:
The Investment Process
- Investment Research: It starts with the screening of suitable security. The decision-making could be about whether to invest in equity, debt, real estate, or gold. Furthermore, one can use online screeners to filter their stocks or mutual funds. But after the screening, a more detailed analysis is a must – this is tough. In direct stock investing, one must take care of the detailed analysis by self. While in Mutual Funds, the fund manager does it for us.
- Picking & Buying an Asset: After investment research, the next step is to buy security among what was analyzed. In the case of direct stock purchase, the investor can invest online by self to buy stocks. But to do it, one will need a Demat account, trading account, and an online banking account. They all come at a price. In the case of mutual funds, the fund manager will do it.
- Portfolio Building: The main task to be done in portfolio management is ensuring diversification. It is a demanding job for an individual investor. Why? Because to diversify, one will need to buy several stocks of non-related sectors. This is both pricy and difficult to execute. But in the case of mutual fund investment, diversification is the job of the fund manager.
- Redemptions: When we are dealing in shares, timing the sale of stocks is as important as timing their purchases. If one has many stocks in their portfolio, timing the sale at times becomes tricky. Though, mutual funds can use software to time the sales.
In terms of the process of investing (or ease of investing), it is clear that mutual funds look inviting. Mutual fund investment can be practiced almost passively. But in the case of direct stock investing, personal involvement is more dominant.
But I’ll like to highlight the most critical aspect of the above comparison. People should not opt for mutual funds because of point number 2, 3, or 4. They must do it for point number one. If one does not know to do the detailed analysis of stocks, they should go for mutual funds.
How to do a detailed analysis of stocks? The method of stock analysis starts with reading financial reports of companies. Any listed company will have to issue an annual report. The annual report consists of a balance sheet, profit & loss account, and cash flow statement. A good stock investor knows to read and comprehend these reports.
Shares or Mutual Funds – Potential Returns
Till now, what we have read weighs in favor of mutual funds. So does it mean that direct stock shall be the second choice of common men? The answer is both Yes and No. Why?
Stocks will be the second choice for people who do not know how to read and analyze financial reports. We can also say that people should stay away from stocks if they have no ways to do a detailed stock analysis. Read: How to analyze stocks in excel.
But if one can analyze stocks, then investing in shares will be the first choice. Why? Because through analysis, one can pick Multibagger stocks that can yield much higher returns than mutual funds.
Check the comparison shown above between returns generated by top stocks and top mutual funds. I’ve considered both stocks and mutual funds from the large-cap space to maintain the parity. The average returns generated by the top 10 stocks shown above is about 30% per annum. Similarly, the average returns generated by the top 10 mutual fund schemes is about 13% per annum.
So you can see, the potential reward of investing directly in stocks is huge. The benefits of investing in stocks post a proper and detailed analysis is worth a try.
Just for the sake of comparison, check what it means by 30% and 13% per annum returns. Suppose you bought two investments today for Rs.1,00,000 each and held them for the next 10 years. One is expected to yield a return of 30% p.a. and the other 13% per annum. Let’s see how much will be the final corpus after 10 years from today:
The investment growing at 30% per annum will grow by 13.78 times in a holding period of 10 years. Simultaneously, at 13% per annum returns, the invest will grow by only 3.4 times in 10 years.
You are still confused about whether to invest in shares or mutual funds? I suppose not. For the majority of people, Mutual Fund is the vehicle suitable for them. Why? Because of their lack of know-how about stock analysis. Even if they have the interest, they do not have the spare time to learn it.
In case you want to enjoy the benefits of shares and the safety of mutual funds, you can try the Exchange Traded Funds (ETF = Stocks + Mutual Funds). ETF’s comes as a package that has the versatility of stocks and safety of mutual funds.
I remember my first purchased stock during the turmoil of the financial crisis of 2008-2009. It was DLF. I could make double-digit returns within few months. But the luck did not last for long. As the Sensex touched back its 20,000 levels by Oct’2010, my luck began to fade. It was the result of investing in stocks without proper research.
When the market is recovering (like it is doing now post COVID), it is easy to make money in stocks and feel confident. But I know that this euphoria and overconfidence will fade soon.
These days almost any Stock, if held for few months, is rendering double-digit returns. But making money from Stock will always not be so easy. Hence, it is better to become cautious and switch sides now. It’s time to do it. Else, if you want to continue investing in stocks, learn to analyze them in detail. Suggested Reading – The concept of intrinsic value.
Have a happy investing.