There are two avenues of investing in equities in India – stocks and mutual funds. Buying shares of companies through stock-brokers is the traditional way of investing in equity. However, over the last 20 - 25 years, mutual funds are increasingly becoming popular with retail investors for investing in equity in India. In this article, we will discuss about investing in mutual funds vs stocks.

What are stocks?

Stocks are shares of publicly listed companies trade in stock exchanges. To buy or sell shares of companies you need to have a demat and trading account. Transactions (buying or selling) in stocks take place through stock-brokers for which they charge a fee based on the size and nature of the transaction – this is known as brokerage charges. Other transaction costs include securities transaction tax (STT), GST etc. There are two ways in which in you can invest in stocks – during the Initial Public Offer (IPO) and/ or through stock exchanges. If you compare stocks and mutual funds investing, stocks have one advantage, you know exactly at what price you are buying the shares at any time during the market hours.

What are mutual funds?

Mutual fund pools the money of different investors and invests them in different securities like stocks, bonds etc. When you are investing in an equity mutual fund, you are essentially investing in a diversified portfolio of stocks. Mutual funds are managed by professional fund managers who have experience in buying and selling stocks. You can invest in mutual funds either directly with the fund house or through a mutual fund distributor. For services provided, Mutual Funds charge a fee known as Total Expense Ratio (TER) to the investors. Unlike stocks, where prices change based on trading activity during stock market hours, mutual fund transactions take place on the basis of NAV declared at the end of the business day.

 

You now know the differences of stocks and mutual funds investing. Let us now delve in risk and return in mutual funds vs stocks.

Risk and Return

Risk and Returns are the two most important aspects of investing in mutual funds vs stocks. There are two types of risk in equity investing, systematic risk (also known as market risk) and unsystematic risk. Let us first understand both types of risks, with the help of an example.

Let us assume that, you invested in the shares of a company. If the market (e.g. Nifty) falls due to weak macro-economic outlook, political factors, global risk factors etc, irrespective of whether the company was doing well in the past or not, the share price of the company is likely to fall. This is known as systematic risk or market risk. It is a risk which affects all stocks.

Let us now try to understand unsystematic risk. The market may be doing well, but a company’s financial results are below expectations due to any reason, then the share price will go down. This is a company or stock specific risk. Apart from stock specific risk, there are sector specific risks also. For example, you invest in an airline stock and there is outbreak of a pandemic. In order to prevent the pandemic from spreading, Government may suspend passenger flights. This will affect the entire airline industry.

Please note that higher the risk, higher the return and vice versa whether you invest in mutual funds or stocks.

Why choose mutual funds over stocks

Lower risk - We have no control over systematic risk and hence they are called uncontrollable risks. But we can reduce unsystematic risks through diversification i.e. investing in a portfolio of stocks. Since diversified equity funds invest in a sufficiently large number of stocks across sectors, exposure to a single stock / sector is quite low and poor performance of one or two stocks gets compensated by the performance of rest of the stocks in the portfolio.

Minimum investments - Another advantage of investing in mutual funds vs stocks is your investment outlay. To create a well diversified portfolio of stocks a big investment may be required. However, you can get exposure to a diversified mutual fund portfolio with a much smaller investment. You can start investing in mutual funds with Rs 5,000. If you are investing through SIP route, then you can start with a monthly investment of just Rs 1,000.

Professional management - One of the main differences between stocks and mutual funds investing is that in mutual funds, your investment is managed by professional fund managers and you may expect good returns over a sufficiently long period of time across different market conditions. Investing in stocks is risky and requires considerable amount of expertise and experience. Many retail investors do not have the expertise or time required to research and select stocks, therefore, mutual funds emerge as a preferred choice for retail investors.

Taxation

In terms of taxation, investing in mutual funds vs stocks is the same. Short term capital gains (investments held for less than 12 months) are taxed at 15% plus cess. Long term capital gains (investments held for more than 12 months) are tax exempt up to Rs 1 lakh and taxed at 10% thereafter. Dividends paid by both stocks and mutual funds are taxed as per the income tax rate of the investor.

However, one of the tax advantages of mutual funds vs stocks is investing in 80C tax savings. By investing in investing in Equity Linked Savings Schemes (ELSS) of mutual funds, investors can claim deduction of up to Rs 1.5 lakhs from their taxable income in a financial year.

Conclusion

In this article, we discussed stocks and mutual funds investing differences. The main advantage of mutual fund is in terms of risk diversification and potential superior risk adjusted returns (alphas) since mutual funds are managed by professional fund managers. Mutual funds are ideal tax efficient investment options for retail investors since they can help investors achieve different financial goals. There are different categories of mutual funds suitable for investors with different risk appetites and investment needs.