With the falling interest rates on fixed deposits and rising inflation, the investors have started looking for avenues that give them inflation-beating returns. The two most popular avenues that are being opted by the investors are the stock market and mutual funds; however, these two do possess higher risk than fixed deposits. So how are these two different and which is better, this article will help you clear those doubts.
What are stocks and mutual funds?
Ever wanted to own a company? Well, stocks allow you to do exactly that. Stocks are an asset that will enable you to own a part of the company. As the owner, you get a profit share in the form of a dividend and can also participate in the company’s important decisions through voting rights. In addition, the stocks can be bought and sold through full-service brokers or discount service brokers in the country.
Mutual funds refer to a pool of asset securities where the investments of several investors are channeled to buy different asset classes like stocks, debt instruments, gold, real estate, and so on. The mutual funds are generally managed by professionals with several years of experience and backed by Asset Management Companies (AMC’s). The mutual funds may be bought and redeemed directly through the AMC’s or independent financial advisors, banks, and brokers.
There is always a constant debate on whether the stocks are riskier or the mutual funds. The first question to be raised in this case is how much experience the investor has in stock markets. For a newbie or someone with less experience, mutual funds may be a less risky option (provided a decent plan is selected) as the funds are managed by professionals who are well versed with the financial markets. Mutual funds also allow the investment to be diversified by investing in several different stocks and asset classes.
Investing in stocks requires a deeper understanding of the markets and the ability to conduct a proper analysis of the companies. It also requires analyzing the decisions of the company’s management since the business decision may have a significant impact on the stock price. As the number of stocks may be lower in the investor’s portfolio, it increases the risk due to reduced diversification. As an investor’s stock portfolio will generally consist of equity shares of different companies, it also reduces the exposure to other asset classes like gold and debt instruments that may outperform the equity markets in case of turbulent times.
The Tax Effect
If you want to save taxes through your investments, the Equity Linked Saving Scheme (ELSS), a type of mutual fund, allows you to claim deduction on your tax filing up to Rs. 1.5 Lakh per financial year. The stocks do not provide any such benefit; however, the capital gain tax for selling the stocks or redemption of mutual funds is the same.
A significant tax advantage that mutual funds offer is that if the fund managers decide to switch between different stocks, the investor is not liable to pay any tax on such transactions. However, in the case of stocks, if you decide to switch investments, you will be liable to pay capital gains tax, if any.
Different types of options
The mutual fund can be seen as a thali in a restaurant wherein you get different types of food items (asset classes for mutual funds) in your thali (mutual fund holding). The type of thali (mutual funds) you buy depends on your appetite (risk appetite for mutual funds). If you are an investor who does not like risk, you may opt for index funds that provide returns similar to the selected index like NIFTY50 or SENSEX. Mutual funds also offer equity-only funds, debt-only funds, a hybrid of debt and equity, and several other such options.
Stocks are like items on the a-la-carte menu. You select the items (stocks) which either you know are good or satisfy your hunger (return requirements). Just like in a restaurant, you would order at least 2-3 items of the a-la-carte menu like a starter, main course, and then desserts, like that in the stock markets you have different types of stocks which are divided into large-cap, mid-cap, and small-cap stocks. But the stock market is a restaurant where only one cuisine is served, stocks. Therefore, it may deprive the investors of investing in other asset classes.
Costs and Returns
Continuing with the above example, the thali allows you to pay an amount generally lower than similar combined items of the a-la-carte menu, but you receive smaller portions in the thali. Likewise, in mutual funds, you receive a smaller share of different companies or asset classes due to the lower price.
Buying the NIFTY50 stocks in your portfolio as per their market weightage would see you shelling out a higher amount. However, investing in an index fund that tracks the NIFTY50 would require a fraction of the amount per unit being invested in the stocks.
The main charges in the case of mutual funds are the expense ratio, which is the amount used to pay off fund managers’ salaries and other expenses. The expense ratio for passive and index funds will be around 0.25% to 0.75%, while it may reach 2-3% for actively managed funds. Another kind of charge in mutual funds is the exit load which is the percentage of the amount that will be deducted from your investment when you redeem shares. However, the number of plans charging and exit load has significantly reduced. As a result, the mutual funds help earn decent returns over time which may or may not beat the market but generally beat the inflation and F.D. rates.
When a stock is bought, several charges like brokerage, SEBI charges, transaction charges, and so on have to be paid. Upon selling the stocks, the investor would have to pay brokerage and D.P. charges. These charges may reduce the returns of an investor, especially if regular trading is done. If an investor buys stocks from a long-term perspective, the charges may not influence the returns significantly. Stocks have the potential to provide significant returns but also tremendous losses. It isn’t easy to have consistent returns in a stock if the portfolio is not well diversified.
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Control and Discipline
In the case of mutual funds, the control of assets part of the fund depends entirely on the fund manager. The investors have no or little control over it. On the other hand, in a stock portfolio, the investor is in complete control of their portfolio.
In the case of stocks, very few brokers offer Systematic Investment Plans (SIP’s). The SIP allows one to maintain discipline in an investor’s financial journey. For mutual funds, SIP’s may be done for as low as Rs. 500.
The selection between mutual funds and stocks mainly boils down to the investment purpose and experience of the investors. Experienced investors may look to directly invest in stock markets to earn higher returns, while novice investors or investors who do not have much time may stick to mutual funds to have some professional management of their investments.
Investors nowadays have another investment avenue available. This avenue is like a mutual fund that allows investors to buy asset classes as per some theme or strategy while the securities are entirely owned by them rather than the AMC’s. This avenue is curated by WealthBaskets by several investment professionals (Michelin star chefs of the investment world).