Should we invest in Equity Mutual Funds or directly in equity shares?

There are two common ways, If we want to invest in equities. First option is we can open demat and trading accounts with a stock-broker to buy or sell equity shares in the stock market. Secondly, we can invest in equity mutual fund schemes.

Mutual fund is the instrument through which Mutual Fund companies pools the money of different people and invests them in different securities like stocks, bonds etc. Many retail investors think that, whether we are investing in mutual funds or through stock brokers, at the end of the day, we are investing in stock markets and therefore both types of investments are the same; hence the dilemma, whether to invest in mutual funds or directly in equity shares?

Here, we will try to understand the key differences of investing in mutual funds and investing directly in stocks.

1.   What is the Risk and Return?

As we all understand that Risk and Returns are the two most important aspects of investing. We invest our money to get returns. In certain investment products we can earn returns without taking any risk, e.g. bank fixed deposits, traditional life insurance plans, government bonds, etc. However, risk free return is the lowest expected return. Historically, risk free returns, on a post tax basis, has not been able to keep pace with inflation over a long time horizon. Hence, If we wish to beat inflation and want to earn higher returns, then we have to take some risks. Generally Higher the risk, higher the potential return, but is not always true. Higher risk and higher returns are fundamental attributes of both stocks and mutual funds, but from an investor’s perspective the question is, how much risk is the investor willing to take relative to returns he or she expects from his or her investments? A deeper understanding of risk is required.

There are two kinds of risk in equity investments, Systematic Risk and Unsystematic Risk. Let us understand both types of risks, with the help of an example.

Systematic Risk or Market Risk is a general market risk, like due to macro-economic factors, geo political reasons etc the market moves ups or down. For example when a single pro reforms political party gets majority in elections market takes it positively where as a hung parliament is taken as negative.

Unsystematic Risk is company or sector specific like Rupee exchange rate and US & European Country’s import policy could have direct impact on IT companies in India.

We don’t have any control over systematic risk and hence they are called uncontrollable risks. But we can reduce unsystematic risks to certain extent; It can be managed by understanding the characteristics of different companies, sectors and their business. how? This needs a detailed understanding and analysis of various sectors and companies. For an individual it may not be that easy however through mutual funds.

2.   Concentrated Portfolio or Diversification?

To reduce Unsystematic Risk, we should have a diversified portfolio, you need to invest in a sufficiently large number of stocks say 40 to 50 stocks to create to an adequately diversified portfolio. The share prices of the 50 stocks may range from Rs 50 to even Rs 25000 per share. As we know that we have to buy minimum one share and cannot buy fractional shares. Even if you buy just 1 share each of the 50 companies, assuming the share prices of the 50 stocks are uniformly distributed in the Rs 50 to Rs 25000 per share range, your minimum capital outlay can be more than Rs 100,000. And If we wish to buy more shares, our capital outlay will be higher. To achieve adequate diversification through direct equity shares, we will need a large capital investment.

Mutual funds, pool the money of different people and invest them in different stocks, in the right proportion, to create a diversified portfolio. The Assets under Management (AUM) of a mutual fund scheme is much larger ( few schemes have more than Rs. 10,000 crores in a single scheme) than the investible capital of an individual retail investor. Each investor in a mutual fund owns units of the fund, which represents a fraction of the holdings of the mutual fund. Therefore, by owning mutual fund units, the investors have the beneficial ownership of a diversified investment portfolio even investing, just Rs 5,000 in a diversified equity mutual fund. Hence we can get diversification benefits that would have required a few lakhs, if we had invested directly in equity shares.

Risk diversification should be an important consideration because it reduces the probability of losses. In terms of risk profile, for the same amount of investment, diversified equity mutual funds are less risky compared to investing directly in equity shares.

3.   Guesswork or Market expertise?

Generally the small and individual investors do not have the experience or expertise in understanding business of various sectors and companies which is required for right stock selections. Most of the retail investors in direct equity shares are speculative or based on guesswork or tips from friends, relatives or their brokers. If someone is investing in a stock, just because, the price has been rising for the last 3 weeks or a month or even a few months, it is still purely guesswork; just because a stock has been rising for the last few weeks or months does not mean it will continue to rise.

Mutual Fund managers have a team of analysts and fund managers who do fundamental analysis where they look at a variety of macro and micro economic factors, analysis of the companies balance sheets, income statements, cash-flow statements, management commentaries etc. Based on the forecast of these factors, employing a variety of methodologies, the fund managers and analysts forecast the future price of the asset. It needs certain set of skills and capabilities (which often includes speaking with the managements of the companies), which retail investors do not have.

A Mutual fund manager’s mandate is to outperform the relevant market benchmark returns. A good manager creates value for the investors through, what is known as, “Alpha”. Alpha is the excess return that the fund manager generates, over and above, the returns expected by the investor for taking a certain amount of risk.

4.   Trading or Systematic Investing?

Equity Share prices are very volatile it also affects the emotions of investors and thus can induce them to buy when market is going up and sell when it is falling sharply. This practise, normally, leads to losses for the investor. Historical data analysis suggests that, the effect of volatility reduces considerably, with increase in the investment horizon. Mutual funds, encourage investors to invest over a long time horizon to meet a variety of long term investment objectives like retirement planning, children’s education, wealth creation etc.

Systematic Investment Plans or SIP is a smart way to invest regularly. It helps investors to take advantage of short term volatility and invest in a disciplined manner by taking emotions out of the investment process which helps to meet their long term financial objectives. SIP also provides the advantage of Rupee Cost Averaging by investing regularly irrespective of ups and downs in the markets. This method helps us to buy units of a mutual fund scheme, both in rising and falling markets, which enables to average out the purchase price of units, resulting higher returns on the investments.

Historical data shows that, long term buy and hold is the best strategy to create wealth in the long term. Equity mutual funds provide solutions to investors to meet their long term financial goals through capital appreciation.

For someone who have lump sum funds to invest but is not sure about the market timing due to volatile conditions, he can invest in a low risk fund, such as liquid fund, and then purchase units of equity fund through a systematic transfer plan (STP). This help to average out the cost of purchase like in SIPs, along with that we also earn higher return on investment (liquid fund returns are usually much higher than savings bank interest). Such a facility is not available in direct equity investing.

Similarly, if we need regular Cashflow for regular expenses it can be done through mutual fund portfolio. Through systematic withdrawal plans (SWPs) an investor can draw a fixed or variable amount of funds from his portfolio. This way he can meet your regular income needs while, the balance invested will continue to earn returns. An investor can also opt for dividend options of mutual fund schemes to get tax free dividends.

And Finally

For small and normal investors who do not have expertise in equity markets, mutual funds are much better than direct equity investments. However If some one have the necessary stock selection and portfolio management skills, he can invest directly in shares through a stock broker. Investing in shares gives the freedom of selecting the shares and to decide when to buy or sell, while in mutual funds, investor will have to depend on the judgement of the portfolio manager. However, the knowledge, experience and judgement of a mutual fund who have team of analysts and fund manager, is likely to be much better than that of a typical retail investor. Henceforth mutual funds are more beneficial for normal retail investors, for meeting their long term financial goals.

Long Term Investment is MARATHON: Be disciplined, steady and have proper goal in mind

We see many marathons around the country at this time of the year (genrally in January/February) where professional runners and common people both run marathons and half marathons in cities across the country. There are many similarities between long distance running and executing long term financial plans. As we understand “Long term wealth creation is not like 100-200 meters sprint where someone starts with a bang will win also. It's like marathon, which should be executed over years in a very systematically manner”.

For marathons or any long distance running it is said “when the going gets tough, tough gets going“. In some cases, this holds true for long term investing as well. Like in marathon for investments also there are certain parameters which should be kept in mind while making investments. These are:

1. SET THE GOAL FIRST

In marathon the goal for a runner running a marathon or a half-marathon is to run the full course, that is to run the 42-km long stretch in one go and not to get down in between.

Similarly in Investments the investor should first prioritise the long term financial goals. For example the goals could be, children's education and their marriage, buying a house or own retirement etc. Like we cannot reach a destination if we don’t know where to reach similarly without goals achieving them is also not possible.

2. STARTING IS THE KEY

In Marathon the runner starts slowly, runs 4-5 kms daily during initial days and increases the distance slowly every time so that the body gets used to the distance.

In long term investments also an investor should start investing with small amounts. He should regularly invest every month and then increase the monthly investment amount as the income increases.

For long term investments a systematic investment plan (SIP) in a mutual fund scheme works in the same way in which one could start with as low as Rs 500/1000 per month and increase the monthly investment amount every year or as and when the investor's income increases.

3. GET USED TO DIFFERENT ENVIRONMENT

In Marathon when the runner gets used to the surface (plain area/ field) on which he is running, then the trainer pushes the runner to change the surface. From plain surface, the runners then starts running on uphill and downhill roads, on sands and other surfaces also so as to make himself ready to face different environments/scenario.

In Investments also normally financial planners advise an investor to start investing in a simple and less risky products, say a mutual fund scheme working of which he could understand easily.

Once the investor gets used to about how the scheme works and gains confidence, then his financial advisor advises the investor to invest in some other schemes which are slightly more complicated/ risky and may have different style of workings/ return potential.

4. BE REMAIN ON THE PATH

In the Marathon during the race, there could be various ups and downs but the runner has to be prepared to face then and overcome all such obstacles and complete the course.

In investing also an investor who is aiming to generate wealth in the long term, has to be ready to face the markets short term ups and downs, which are referred as volatility. When an investor is investing for building his retirement corpus, he should stick to that goal even during volatile market phases. Here the focus should be long term and should avoid the urge for instant profits for long term rewards.

5. MAINTAIN THE PACE

For a marathon runner, It is very important to maintain a steady pace through the 42-km run. Its not advisable to start at a very high speed and spend the full stamina at the beginning itself.

Similarly for long term wealth creation too one should never start with a large sum of money. Even if one has a large amount at his disposal for investing, it's always advisable to put the money in a liquid fund and start an systematic transfer plan so that the whole system works like an SIP from a liquid fund. This way the investor spreads out the risks and averages out his cost of acquisition.

6. REVIEW AND REBALANCE

A Marathon runner needs to check if he is running at regularly that whether it is as per the plan. And if it is not then he may have to change the pace/plan.

In Investments also during the financial journey, the investor also needs to review his financial plan. And in case it is found that they are off track he needs to rebalance to bring it on track.

7. EYES ON LONG TERM GOALS, NOT THE SHORT SPRINTS

During the race, a marathoner should never try to increase his pace suddenly and start running very fast. They are trained for long distance runs to maintain a steady pace which he is able to maintain throughout the race. They are allowed only minor variations in speed but not very significant variation.

Similarly for long term investments, investor should avoid the short-term attractiveness of trading on tips and market information. Tips could earn fast bucks, but it's almost impossible to successfully make money by trading on tips. So long term investors should avoid the lure of trading on tips.

8. REACHING THE FINISH LINE

In long distance runs like marathons, the runner should not stop immediately even after completing the marathon, He should run slowly for some short distance and then rest.

Similarly for long term investing an investor should not withdraw at once but slowly transfer the money from equity to debt based products and then he may take out the money slowly form there.

The Impact on individual’s Personal Finances by the Budget-2017

In todays budget there were many more things then just reduction of income tax by 5% for the people having income below Rs. 5 lakhs. Lets look at the fine prin of the budget and what other changes which may impact the finances of an individual.

1.     Revision in income tax rate: 

The existing rate of income tax for individual assesses drawing an income between Rs 2.5 lakh to Rs 5.0 lakh has been reduced to 5% from the present rate of 10%. This tax reduction will bring about a savings of Rs 12,500.

2.     Reduction in tax rebate under Section 87A of the Income-tax Act, 1961: 

The existing provisions of Section 87A provide for a rebate up to Rs 5,000 from the income-tax payable to a resident individual if the total income does not exceed Rs 5.0 lakh. It is now proposed to amend Section 87A so as to reduce the maximum amount of rebate available under this Section from existing Rs 5,000 to Rs 2,500.  This rebate shall be available to only resident individuals whose total income does not exceed Rs 3.5 lakh.

3.     One page Income-Tax Return form: 

For individuals earning an income up to Rs 5 lakh (other than business income) a one page Income Tax Return form has been proposed. This would make tax filing for individuals easy.

4.     Fee for delayed filing of return: 

A fee of Rs 5,000 shall be payable, if the return is furnished after the due date but on or before the 31st day of December of the Assessment Year. A fee of Rs 10,000 shall be payable in any other case.

However, in a case where the total income does not exceed Rs 5.0 lakh, it is proposed that the fee amount shall not exceed Rs 1,000. This is aimed at instilling a sense of discipline amongst tax payers.

5.     Increased surcharge: 

A surcharge of 10% on all individuals whose taxable income is between Rs 50 lakhs and Rs 1 crore.

6.     Change in the period of Long Term Capital Gain for immoveable property:

Under the current provisions, to qualify for long-term asset, an immovable property is to be held for a period of 36 months or more. However, it is proposed to reduce the period of holding to 24 months (i.e. 2 years). This amendment will give respite to individuals who are looking to sell their properties and aid liquidity in the asset class.

7.     Change in base year for indexation benefit: 

The base year for calculating the indexation benefit has been revised from April 1, 1981 to April 1, 2001. It was highlighted that assesses were finding it difficult to compute the capital gains in respect of a capital asset, especially immovable property acquired before April 1, 1981 due to non-availability of relevant information, especially the fair market value.

8.     Expanded the scope of long term bonds under Section 54EC:

    The scope of Section 54EC of the Income-tax Act, 1961 has been widened to all bonds redeemable after 3 years which have been notified by the Central Government.

The existing provision of section 54EC provides that capital gain to the extent of Rs 50 lakhs arising from the transfer of a long-term capital asset shall be exempt if the assesse invests the whole or any part of capital gains in certain specified bonds, within the specified time. Currently, investments in bonds issued by the National Highways Authority of India (NHAI) or by the Rural Electrification Corporation Limited (REC) are eligible for exemption under this Section.

9.  Rationalisation of deduction under Rajiv Gandhi Equity Savings Scheme (RGESS) (under Section 80CCG): 

Since limited number of individuals have availed this deduction and to rationalize multiplicity of deductions under Section 80C, the Finance Minister proposed to phase out this deduction by providing that no deduction under Section 80CCG shall be allowed from Assessment Year 2018-19.

10. Restriction on set off of loss from house property: 

In lines with the international best practices, it is proposed to restrict the set-off of loss under the head "Income from house property" against any other head of income to Rs 2.0 lakh for any Assessment Year.  However, the unabsorbed loss shall be allowed to be carried forward for set-off in subsequent years in accordance with the existing provisions of the Act.

11. Tax-exemption to partial withdrawal from National Pension System (NPS): 

Partial withdrawals from NPS not exceeding 25% of the contribution made by an employee would be exempt from tax. This proposed provision is in addition to the current provision of exempting 40% of the amount payable to the subscriber on closure of the account or opting out of NPS.

12. Rationalisation of deduction for self-employed individuals depositing for NPS: 

Under the current provisions of Section 80CCD, an employee subscribing for NPS is permitted a cumulative deduction of 20% of salary, where as in case of other individuals, the total deduction under Section 80CCD is limited to 10% of gross total income

In order to provide parity between an individual who is an employee and an individual who is self-employed, it is proposed to amend section 80CCD so as to increase the upper limit of 10% of gross total income to 20% in case of individual other than employee.

13. Rationalisation of deduction under Rajiv Gandhi Equity Savings Scheme (RGESS) (under Section 80CCG): 

Since limited number of individuals have availed this deduction and to rationalize multiplicity of deductions under Section 80C, it is proposed to phase out this deduction. No deduction under Section 80CCG shall be allowed from Assessment Year 2018-19.

14. Restriction on cash transactions: 

In order to achieve the mission of the Government to move towards a less-cash economy and curb black money, it is proposed to insert Section 269ST of the Act.

No person shall receive an amount of Rs 3.0 lakh or more—

• In aggregate from a person in a day;
• In respect of a single transaction; or
• In respect of transactions relating to one event or occasion from a person,

Only an account payee cheque or account payee bank draft or use of electronic clearing system through a bank account shall be permitted.

Moreover, in order to bring transparency to the source of funding by political parties, no donations of Rs 2,000 or more can be made in cash. Political parties will be entitled to receive donations by cheque or digital mode or electoral bonds from their donors.

Finally:

To keep our finances in healthy in the long term, we should ensure that we are saving and investing wisely in wealth creating investment avenues while our  endeavour to achieve many financial goals in life. Let’s Be a smart and a wise investor in your journey to wealth creation; don’t depend only on union budgets.