Mutual fund investments vs direct investments in stocks: which works better?

Investment and risk taking go hand in hand. Whenever you are putting your hard-earned money into something you hope to receive great returns from, you are running the possibility of either becoming richer overnight or losing that much and even more. To put it simply, an investment is a gamble which requires considerable research, vision, and educated guesswork.

The question of finding the most reliable form of investments keeps springing up from people who, literally, want to put their money where their mouth is. And as a result, people often find themselves caught at the junction of two diverging roads – the one down mutual fund investments and other leading to direct investing in stocks.

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It is widely assumed that making investments through mutual funds is a safer option than the latter. This is primarily because it is handled by professional fund managers who ensure that they select stock portfolios which guarantee successful long-term returns. However, a recent report by Economic Times revealed that only about 4.5 percent of the total market capitalisation in India is held through equity funds. On the other hand, direct holding by individuals is nearly 22 percent of the market capitalisation. This indicates that the practice of directly investing in stocks is more favourable to a select group of Indians with strong purchasing power.

However, the key words here are ‘select group’. Direct investing is practiced more largely among the rich in India, primarily businessmen and businesswomen who possess astute knowledge of the daily changing stock market and follow it to the bone. Choosing between the two kinds of investments also depends on a person's risk taking ability, return expectations, and the ability and inclination to manage a share portfolio. And sources tell us that an increasing percentage of the average Indian population is turning towards mutual fund investments. And here’s why.

Professional money managers

Mutual fund investments require professional help from a fund manager whose only mandate is to expressly monitor and manage the investments that his fund makes. As an investor, you do not have to spend time examining the fund manager’s personal history. Rather, you should go by his or her past experience – the kind of returns they have managed to procure over the years – and decide on the basis of that. The many components to making an investment, which include picking stocks, tracking them, making sector and asset allocation, and booking profits when required, are all handled by the fund manager. The investor only has to check from time to time if the fund manager is sticking to the mandate and delivering a return superior to the corresponding index.

The constantly transforming Indian mutual fund industry

In a study conducted by Scripbox, it was found that among 25 equity mutual funds taken over the past 10 years to compare the median yearly return for these funds to the yearly returns of the Nifty, all showed significantly different returns from one another. At the same time, the cumulative annualised return of equity mutual funds over 10 years was significantly higher than the Nifty. On an average, about one-fourth of the top 25 funds were replaced by new funds every year. The analysis of the same report surmised that it is the periodic evaluation and rebalancing that works as the secret ingredient of better investing.

Stable returns

More often than not, mutual finds ensure more stabilised returns on your investments than direct investment in stocks. The latter, though it holds the possibility of procuring even higher returns than the ones garnered from mutual funds, always entail a greater risk, considering that a stock value and price can change dramatically within the matter of days.

Tax-benefits and lower cost of investing

Mutual funds provide a tax benefit of up to rupees one lakh under Section 80C when you invest in an equity-linked savings scheme, which has a lock-in period of three years. Additionally, there is no capital gains tax on stocks sold by the fund, as long as you hold your equity fund for a year or longer to avoid short-term capital gains tax on the investment, which can subsequently lead to significant benefits for you as an investor in that fund. This is in comparison to the amount you have to pay if you’re making direct investments on portfolios that you choose yourself. For this, you have to pay 15 percent short-term capital gains tax if the stocks are sold within one year.

At the same time, the cost of investing is significantly lower for mutual funds than direct stock investing. While you will be required to pay 0.5 to one percent as brokerage along with additional demat charges for buying and selling shares directly, mutual funds pay only a fraction of the brokerage charged to individual investors on account of their scale. Additionally, mutual fund investors do not require a demat account.

Defined time-period and diversification

As someone directly handling your shares, you are required to dedicate the time and effort into keeping a daily check on the stock market and the returns you could be expecting on any odd day. At the same time, you need to dip a toe in a highly diversified portfolio that lists at least 20 different stocks to ensure that you get returns from at least some of them. However, in most cases, direct investors may not possess the resources or bandwidth to create such a portfolio. In contrast, a mutual fund investment is usually undertaken with a specific time period in mind, where you can evaluate the returns as per the set date, most of which is anyway being handled by your fund manager. Additionally, since you, through your fund manager, are identifying and buying units of the fund that invests across several stocks, you will be awarded with a diversification benefit without having to invest in a huge corpus.

Which way do you believe marks India’s future? Direct investment in stocks or mutual fund investments?