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Invest in Equities screams the personal finance literature(newspapers, magazines, blogs). If one wants to invest in equities there are two ways, Stocks and Mutual Funds. In this article, we shall explore why is it recommended that one invests in Equities?What are the pros and cons of investing in Stocks, in Mutual Funds?

Investing in Equities

Why should one invest in equities? Inflation ! Inflation erodes savings of citizens. So if the inflation rate is 8%, a Rs 100 earned will be worth just Rs 92 after a year if it is not invested. So If you invest Rs. 1 lakh (1,00,000 @ 12% p.a.), with the annual inflation rate being 5% in the economy, then the real return on your deposit is 12%(nominal rate) minus 5%(inflation rate), i.e. 7% p.a.(real rate) This is because after one year when your deposit matures you will have to pay 5% more for any purchases owing to that being the rate of interest in the economy for a year.  That is why one always has to be on the lookout for investments whose returns are more than the prevailing inflation rate. Our article Understanding Inflation explains inflation on detail.

Traditionally People have invested in Gold and real estate as hedge against inflation. Gold can be held in the form of -mining shares, coins ,jewellery or ETF. But Gold is struggling to regain its role as the world’s most respected medium of exchange. It is engaged in this struggle with the U.S. dollar. Gold has become more expensive to buy in India even as it has under-performed in relation to the dollar .  Real estate as an investment carries the taboo of being very illiquid. The transactional costs of getting in and out of the deal are very high. Also the initial investment itself is very high and one cannot correctly predict the appreciation.

Equities have the potential to increase in value over time.  Research studies have proved that the equity returns have outperformed the returns of most other forms of investments in the long term. Investing in equities over a long period is one of the best ways to stay ahead of inflation. Over the last 10 years, the Nifty has returned +15% a year compared to the 7% average inflation rate. Returns of various asset classes over 1 year, 5 year and 10 years (as on Feb 2014) is given below in the image. (Click on image to enlarge). To invest in stock market one can either invest directly i.e stocks or through mutual funds. Our article Returns of Stock Market, Gold, Real Estate,Fixed Deposit

Return CAGR of Equity, Debt etc over different time periods as on Feb 2014

Return CAGR of Equity, Debt ,Gold, Real Estate over different time periods as on Feb 2014

Investing in Stock Market

I lost money in 2008 and then stopped investing” or “My uncle or father or cousin lost money in share market… ” or “stock market is all about scams , manipulation see NSEL crisis ..Harshad Mehta scam” is what we hear when you say you are investing or want to invest in stocks. Parents talk abouthow they invested in fixed deposits, post office schemes and have done okay for themselves.” Among all asset classes, stocks are the most volatile makes it difficult for investors to negotiate equity markets.

When you buy stock of company, you become one of its owners. If the company does well, you may receive part of its profits as dividends and see the price of your stock increase and are entitled to various benefits, like attending the shareholders meeting, voting right etc.But if the stock price falls, the value of your investment can drop, sometimes substantially. A stock has no absolute value. At any given time, its value depends on whether its shareholders want to hold it or sell it, and on what other investors are willing to pay for it. If the stock is hot, and lots of people want shares, the price may go up. If a company is losing money or a particular industry is doing poorly, those stocks may drop in value.  Investors’ attitudes are determined by several factors: whether or not they expect to make money with the stock, by current stock market conditions, and the overall state of the economy. Our article Our article Stock Market Index: The Basics explains stock market Index,Sensex Nifty and News that affect the Stock Market explains in detail the various factors that affect the stock market.

To invest in stock market, investor needs to analyse and choose the equity shares to invest in. This is easier said than done. Choosing a good equity share requires broad understanding of the economy, sectors and the company itself. One has to go through the financials of the company like balance sheet, profit and loss account as well as all other parameters that indicate the health of the enterprise. It is said that as individual investors, most people do not have the capability nor the inclination to do this. Unless, they have a good broker or advisor, they may end up taking or simply choose bluechips.  if you have been taking tips from the wrong person you could end up a sucker. A number of retail investors have not gained from equities’ performance over the long term. Usually they get drawn in after a good cycle and suffer when it turns.

Stock Market thy name is volatility! The boom that ran from 2004 to 2007, the slump that hit in 2008, the sharp recovery a year later, interspersed with numerous short periods of extreme volatility has made people hesitate in investing in the stock market because they consider it too risky. Afraid of choosing the wrong stock or being battered in a bear market, they prefer to stick with investments they consider safe. It is said that Direct stock investing is more suited for people who have the skill and knowledge to make the right picks and have time to monitor and manage their investments on a daily basis. Our article Ups and Downs of Sensex explains the returns of Sensex, milestones of Sensex in detail.

Investing in Mutual Funds

Investing in equities through mutual funds is the suggested route. A mutual fund is a diversified group of stocks, bonds, or other assets contributed by investors and managed by professional money managers. Systematic Investment Plan or SIP is the recommended option for investing in mutual funds. 

  • When you invest in a fund from a good fund house, there is a full-fledged research department, there’s an experienced full-time fund manager who has years of track record(thoroughly analysed by researchers) of making equity investments.
  • Compared to directly picking stocks, mutual funds are a more suitable route for a lot of people. It takes less effort, less time, less experience and less specialised knowledge to get good returns from equity mutual funds than it does from directly trading in equities.
  • Stocks investing is restricted to Stocks only. You can choose a large cap stock, mid cap stock or small cap stock, but finally it will be equity asset class. However, mutual funds can invest in mix of asset classes fixed income or debt,gold,international.
  • Monitoring in mutual funds is relatively low (not on daily basis) because the job of monitoring is done by the fund manager but you do need to review your portfolio at least once or twice a year.
  • When you invest in a single stock or bunch of stocks (3-5 scrips), the change in it’s value is very high. On a given day it can be extremely volatile. Mutual fund on the other hand is not that much volatile by nature, as the diversification is very large and at a time 50-100 stocks are covered. Different kinds of stocks from different sectors and market capitalization are involved in mutual fund and the over all change in value is thus less volatile (other than extreme days).
  • For small investors mutual funds are a better option.For eg in one is investing Rs 5000 a month in Sensex, do you have time, expertise and is it worth spending time going through financial data of the thirty companies?
  • Mutual Funds provide various investment options to investors like Systematic Investment Plan (SIP), Systematic Transfer Plan (STP), Systematic Withdrawal Plan(SWP). There are also different strategies like growth, contra, mid-space, ELSS.

 The primary appeal of mutual funds is that they are professionally managed and provide diversification. Every year, dozens of financial magazines, newspapers, and newsletters dutifully report the top-performing mutual funds, based on 1-, 2-, 5-, or more year time periods.   But Fund houses charge expenses, and if there are days of meagre returns, nothing is left for the investor after the fund house deducts expenses for his investment. The other problem that one faces with investing in MF is its degrading and upgrading of rating frequently. Our article Rantings of a Mutual Fund Investor expresses the frustrations of a Mutual Fund Investor

Video on Comparing Stocks and Mutual Funds

Following video compares Stocks and Mutual Funds

Somewhere I read about comparing swimming to investing in stocks and mutual funds. Difference between swimming in a pool and swimming in an ocean or river? Swimming in a pool is easier as it is a controlled environment. Swimming in a river or ocean is far more difficult as one has to contend with the surging waters, currents and whirlpools.There are  other lurking dangers like alligators, sharks and so on, which can cause harm. So, even those who swim regularly in pools aren’t always willing to jump into a river or ocean. Apart from the perils involved, swimming in the open, also calls for higher level of skills. It even involves different, special skills, not required in a pool. So no guesses as to investing in mutual funds is like swimming in pool, while investing in stocks in like swimming in an ocean or river.

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Both mutual funds and direct equity have their own pros and cons. For beginners in equity market and those who don’t have adequate time to monitor their investment, they should invest in equity market through mutual funds as mutual funds provide various benefits as Professional management, Portfolio diversification,Liquidity, Convenient options. Often we feel that stocks involve too much risk.But there is some risk attached to every investment product. It’s just that it is more apparent in some and not so in others.  The caution that past performance is no guarantee of future profits is absolutely valid. Investing isn’t about guarantees. It’s about balancing risk with reasonable expectations of reward.

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Do you agree that one should invest in Equities? Do you invest in Stocks or Equity Mutual Funds? What principles/guidelines do you follow for investing in Stocks or Equity Mutual Funds.