Last Updated on May 21, 2017 at 3:52 pm
‘Mutual funds are for sissies’. Excuse the expression, but I wonder if you have heard that or some version of that from stock investors? Many stocks investors (not all) tend to look at mutual fund investors as children of a lesser god. Not that I care, but I often see extreme generalisations both for mutual fund investing and against mutual fund investing that I thought it might be a good idea to discuss the key difference between mutual fund investing and stock investing. If that is clear, the choosing between the two should become that much easier.
No, this is not a post that goes, “invest in stocks if you have the time to research blah blah … and that mutual funds are an easy way for retail investors to participate in the equity market”.
Mutual funds* are by construction and definition generally** less risky than stocks. An example from Backtesting a three stock portfolio: L&T, ITC, Axis Bank
The standard deviation in monthly returns for the 3-stock portfolio is 39%. A good 30% larger than the corresponding number for FIBCF.
FIBCF is Franklin India Blue Chip Mutual Fund.
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* By Mutual fund, it would apply to any equity mutual fund, but I am specifically referring to the more popular diversified funds.
Most diversified mutual funds hold anywhere between 30-60 stocks in their portfolios. The exposure to an individual stock is limited to 10% by SEBI. This greatly reduces concentration risk as compared to the portfolio of a reasonably intelligent retail stock investor. Also, the total exposure to a stock by the AMC should not exceed 10% of total AUM (of all funds).
The exposure limit cuts both ways. While it ensures diversification and risk reduction, it could also act as a deterrent to returns. This is the main price a mutual fund investor has to pay (forget the expense ratio and fat fund manager salaries). This is why mutual funds (even sectoral ones) are diversified by construction.
Concentration risk is also a double-edged sword. If thing go right, then it can lead to spectacular riches (assuming enough money was invested!!). However, if things go wrong, then not many can get up from such a fall.
Concentration risk is the price that the direct stock investor has to pay (unless their portfolio resembles a mutual fund!). The intelligent ones rely on their nose, gut and research while buying a piece of the business. Less said the better about free lunch stock investors.
Direct equity investing with professional recommendations is also subject to a form of concentration risk – expertise risk. The experts can get it wrong too.
Hey, don’t mutual funds also suffer from such expertise risk? Yes, but relatively speaking, the 10% rule limits both the associated reward and the risk!
** I said mutual funds are generally less risky than stocks. However, if there is an all round market crash like in 2008, then diversification will not help much. Which is why they (ought to ) say,
“M U T U A L F U N D S A R E S U B J E C T
T O M A R K E T R I S K S”! (in slow motion).
So those who don’t mind taking on concentration risk combined with expertise risk (either self or a pro) can invest in direct equity. Those who want to do it right will not mind the time and effort involved. So no big deal there.
Naturally, young earners can take on such risks. They can afford to get it wrong at least once or twice, maybe even lose a lot, start over again with the experience.
Investors who do not wish to take on such risks, or can think of better ways to spend their time can choose mutual funds. Nevermind the jibes from the direct equity guys. It is not possible to compare the performances of a regulated portfolio with individualistic ones and conclude one is better than the other.
Easy peasy lemon squeezy!
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