Comparing mutual funds and individual stocks
Comparing mutual funds and individual stocks
Investors can choose between mutual funds and individual stocks to grow their wealth over time. Mutual funds invest in many companies and are managed by professionals, providing diversification and an expert approach. Individual stocks, selected by investors themselves based on company fundamentals, offer the potential for higher but volatile returns. Each option has its pros and cons with respect to costs, risks, returns and taxes.
Diversification benefits
Mutual funds invest in a basket of stocks and bonds, providing diversification. Individual stocks concentrate risk in one company. For example, a banking fund may invest in 15-20 banks, reducing risk from any one bank’s performance. Investing in only one company’s shares exposes you to risks specific to that company. Diversification helps contain volatility and the impact of individual company declines on your portfolio. Mutual funds also allow you to invest a small amount every month through SIPs. You can use an SIP calculator to understand the investment better as well.
Expert management
Mutual funds are managed by professional fund managers with research teams. They are equipped to evaluate companies, sectors and the economy holistically and allocate accordingly for the fund’s objective. As an individual investor, researching these aspects across many companies and keeping updated is difficult. Fund managers also actively monitor markets and make timely entry-exit calls and necessary portfolio changes. Your own stock picking skills may lack these advantages.
Lower costs
Brokerage, accounting and research expenses are lower when spread across a fund compared to individual stock portfolios. Funds charge an expense ratio of 1-2.5% annually for these services. Brokerage on stock transactions can cost 0.2-0.5% of trade value per transaction – many transactions lead to high costs. The convenience of professional management through mutual funds comes at a lower overall cost than managing your stock portfolio independently.
Less volatile returns
Returns from mutual funds are less volatile than individual stocks due to diversification. Stock prices fluctuate sharply based on company-specific factors, while a fund’s NAV depends on the overall performance of many stocks and the economy. For example, if you invest Rs. 1 lakh in a bank fund and Rs. 1 lakh in company shares, the fund NAV may rise/fall 10% annually based on sector performance but the company shares could gain/lose 25% or more based on its results or policies alone. Fund returns, though lower at times, are more stable.
Tax efficiency
Capital gains taxes are lower for equity mutual funds. Individual stock sales may lead to higher taxes based on period of holding and whether STT is paid on transactions. Equity funds only pay 10% tax on long-term gains and 15% on short-term gains. Dividends from mutual funds are also tax-free, while individual stock dividends attract 10% tax. Funds provide higher after-tax returns, especially for those in higher tax brackets.
For most investors, mutual funds offer a better trade-off between risk and return due to managed diversification, lower costs and tax efficiency. However, active stock picking by knowledgeable individuals focused on long-term investing may still generate higher returns. Assess your objective, skill and risk tolerance to choose between mutual funds, stocks or a combination of both for optimum portfolio performance. Review periodically as risks and skill levels change to make adjustments that continue to benefit your investment goals.
