This article is about a choice that has to be made by everyone who would like to reap the rewards of investing in equity. They could either be a direct equity investor: do their own research and analysis and choose which stocks to buy and sell, and when to do so. Or, they could invest in equity mutual funds. Which is the better way? To me, the answer is clear, and has been so for years. This is despite the fact I began my career as an equity analyst, and now run a business that publishes an equity investing magazine and have an in-house team of equity analysts. Let me explain the reasons and try to convince you, too.
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But first, let’s establish some basics about when you should invest in equity and when you should not. The basic principle is this: keep all the money that you are likely to need for at least the next five years in a fixed-income investment like a bank deposit or a liquid fund. Longer term investments should be invested in equity funds.
Coming back to the key point, let’s examine why mutual funds are better than directly investing in stocks. This brings to my mind a conversation that Warren Buffett had with a shareholder at his company’s AGM a few years ago. In response to a question about investing in stocks versus funds, Buffett said that there are professional investors, and then there are amateurs who invest. Being the former requires a lot of work and research, which many amateurs don’t have the time or inclination to do. He said that the main problem for most people lay in “trying to behave like a professional when you aren’t spending the time in the game needed to be a professional.”
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Professional investment research and management is the biggest reason why investing in funds makes more sense. There are hundreds of possible stocks to choose from. A mutual fund house will have a team of full-time researchers and analysts to find new opportunities and monitor old ones.
Diversification is the other big factor. Diversification is the biggest source of safety (and thus eventual higher returns) in equity investing. Diversifying across sectors and industries requires discipline, process as well as the ability to monitor a wide range of investments.
On convenience, too, mutual funds score higher than directly investing in equity. A sensible mutual fund portfolio has, at the most, five or six funds whereas a well-diversified equity portfolio will have at least 10 or 15 stocks, generally with a larger volume of transactions. Therefore, there’s much less paperwork with funds and accounting tends to be a lot simpler. Tax calculations are much more straightforward and far less likely to be disputed by the taxman.
Fund investing is significantly tax efficient and you will pay a smaller amount of tax for equivalent returns. Direct equity investing needs more frequent buying or selling as individual stocks become more or less desirable. These transactions bring a tax liability if the period of holding is less than a year. However, in an equity mutual fund, this trading is done by the fund manager inside the fund, where it is not liable to pay tax.
Advocates of direct equity investing generally say that it’s possible to earn higher returns from buying and selling stocks oneself. I agree, it’s POSSIBLE. There are people who do it. The problem is that such people are few and need a lot of time and effort, and perhaps luck. This brings us back to what Buffett said about amateurs and professionals above.
