Mutual Fund Investing vs Stock Investing

'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.

* 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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9 thoughts on “Mutual Fund Investing vs Stock Investing

  1. Govarth

    The real deal is not to get better returns than MFs, but to consistently get better returns with lesser risk, and over a long period. No wonder hedge funds have lost to Buffet's challenge (outperforming an index fund).

    In portfolio construction, it is very important to avoid big mistakes. Howard Marks is brilliant in educating people about the need to avoid big mistakes. Just by avoiding the big mistakes, the portfolio can beat most other instruments. I find that MFs provide us the framework to avoid such big mistakes. Most stock pickers rarely talk about their performance over a long period (decade plus). All it takes is one bad stock to plunder the returns. It is true that some stock pickers do better. I wonder if there's any study on MF returns vs. stock returns from individual investors. I for one, find MFs to be far more safer.

    Reply
  2. Sudip

    Hi, kindly suggest 1.I have a sip ongoing on Icici value discovery fund growth and Icici pru focused blue chip equity @2500 each. I would like to add sbi blue chip fund growth and sbi magnum mid cap and increase the total sip of all four MF to 25000 monthly. Kindly suggest about the funds and what will be the average return altogether.

    Regards,

    Reply
  3. P A Bande

    How MF bosses/senior Managers can generate so much wealth for themselves ? Even if returns of so called star funds of the house are not upto the mark !

    Reply
  4. Vijay Xavier

    Retail investors can beat concentration risk and expertise risk by following a value investing approach to direct equity investing. This is especially true in India's evolving equity markets as there is still significant information arbitrage and asymmetry as compared to mature equity markets in developed countries.
    Further with various retail online trading platforms providing DIY stock picking services (Trading + Research) and retail investors can follow certain common sense based principles such as investing through:
    1)Stock specific SIPs in blue chips with industry leadership (30% + market share for pricing power)
    2) Good growth prospects (at least double digits)and reasonable valuations (sector specific)
    3) High ROEs (15%+)
    4) Low PE (<16), PBV, Low Debt-Equity
    5) Consistent and good dividend payouts (At least 2% & payouts above 75% for the preceding 3-5 financial years)
    6) Defensible biz moats (tech, branding, supply chain, IP, channels etc.);
    7) Max sector exposure at 10%
    8) Avoid companies with strained ESG (Environmental Sustainability, Socially Responsible & Corporate Governance) track records such as ceratin PSUs, metals, real estate, construction companies

    A retail investor can easily accumulate shares of 5-6 companies annually and over a 7-10 year period have a diversified, high-quality portfolio of 50-60 shares accumulated at reasonable valuations and with a high probability of beating 90% of actively managed equity mutual funds over this 10 year period, without paying up for poor fund manager performance through high AMC charges (1.5-2.5 %) and agent commissions (1-1.5%).
    It's a myth that successful equity investing is rocket science which is best left to professionals. Aam Aadmi Investors can learn successful equity investing through patient, research-based, common sense led approach, especially if the investment duration is 10 years + and easily match BSE Sensex Total Returns (30 year ~17% i.e. Capital Appreciation + Dividends).
    IMHO Investing in equity mutual funds in India makes sense if one is really busy, lacks ability & willingness to invest time & effort to learn fundamental analysis & value investing concepts and is afraid of missing out on following the herd 🙂
    Further the only time equity fund investing should be considered is when one wants to leverage tax benefits provided for tax planning (section80C and related Income Tax Act provisions) through investments in ELSS, NPS & MF Retirement plans.
    Going forward it is highly unlikely that current and future professional active equity MF managers would be able to beat broad based indexes such as CNX500 and justify their active fund management charges. Investors would be better off investing in low cost-low tracking error index funds.
    The ability of Indian active equity fund managers to beat the Sensex / Nifty over 10 / 15 / 20 / 30 year i.e. long term horizons leaves a lot to be desired; thus investors would be better off utilizing mutual funds for investing in NPS, ELSS & MF Retirement plans to leverage Section 80C and related benefits and invest their balance hard earned monies directly into equities through the above-mentioned approach.

    Reply
    1. bharat shah

      'Further with various retail online trading platforms providing DIY stock picking services (Trading + Research)'
      Will you kindly name some such retail platforms?

      Reply
  5. P A Bande

    Vijay , Nice one..Also MF cannot make u rich .. They may beat market returns and managers rich. Active investor must put 50% of his equity portion directly in market.

    Reply
  6. Maruti Bilgoji

    Hi Pattu,

    I didnt get one point "The exposure to an individual stock is limited to 10% by SEBI", how come PPFAS Long Term Value Fund has 11.5% in Alphabet Inc?

    Reply

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