Direct equity or mutual funds?

Do you buy shares directly from the stock market or do you invest in equity mutual funds? The former is engaging and fulfilling and the latter, less risky for you. In this article, we discuss when it is meaningful for you to invest in mutual funds and when you should directly buy shares.

The discussion relating to direct equity investment and mutual funds rests on your investment objective. Are you investing to earn higher returns? Or are you investing to achieve life goals? Suppose you want to send your child to the US seven years hence for her college education. Your objective would be to accumulate enough wealth to pay for her education. True, having more wealth in your daughter’s education investment account will not hurt. But having more wealth also means taking higher risk. Which would you prefer: Taking minimal risk to achieve your goal or taking higher risk to earn higher returns and, in the process, increasing the risk possibility of failing to achieve your goal?

Needless to say, you would prefer to take minimal risk because accumulating wealth for your daughter’s education is important. Now, direct equity investment carries high risk. Why? To be successful at direct investment, you should be able to pick the right stocks and then sell them at the right time. Are you confident of doing both? Importantly, do you have the time to continually engage in this process?

Many individuals start their direct investments in all enthusiasm but lack the discipline to continually allocate time to make the investment decisions. If you face similar issues, you should consider investing in equity mutual funds to meet your life goals. The process is simple. You have to set-up a monthly systematic investment plan on mutual funds that you think are appropriate to achieving your life goal. If you find it difficult to select active funds, you should start with an SIP on a Nifty Index fund. It is also behaviourally optimal to meet your life goals through equity mutual funds. Why? Direct investment requires active decision making — when to buy and sell shares. You could have bought the share at a lower price or sold the shares at a higher price. SIP on equity mutual fund helps you distance yourself from such active decision making. And that reduces regret. Besides, index fund does not have the risk of under-performing the market, thus reducing the failure to achieve your life goal.

At times, you may invest just to beat the market. Such investments form part of your satellite portfolio in the core-satellite framework. The objective of this portfolio is to simply capture short-term price movements in the equity market. You should make direct equity investments in your satellite portfolio. Why?

Your holding period for shares in the satellite portfolio is less than one year. But funds typically impose a penalty if redemptions are made from investments held for less than one year. Such penalty (typically one per cent) significantly reduces your short-term gains.

Then, there is the behavioural argument. You derive immense satisfaction when you identify a stock and profit from the buy-sell transaction.

You do not get the same sense of fulfilment when your mutual fund investment generates similar returns! Further, your inability to continually devote time to buying and selling shares will not hurt; satellite portfolio is not aligned to your life goals. You should, however, seek professional advice if you are unable to buy and sell stocks at optimal prices.

The writer is the founder of Navera Consulting. Send your queries to portfolioideas@thehindu.co.in