May 03, 2012,15.35 IST
Why should a lay investor buy MFs instead of direct equity?
There are very few who do their own research before buying/selling shares. Most people invest in equity just based on tips or advice. It could be their broker's advice; or a friend's so-called hot-tip; or a casual conversation at a party; or a recommendation on some TV channel/business magazine; or even a chance remark overheard in the local train/bus. Forget about knowing what the company does or who manages it, sometimes they wouldn't even know the proper name of the company.
This laziness, ignorance and casual approach is, more often than not, likely to cause losses. Yet this is what is happening day-in and day-out. The responsibility of such losses is then unfairly put on the stock markets. It is important to realize that the fault here is of the investor and not the investment.
Is a car risky? It depends. If it is being driven by an untrained or drunk driver, it can be very dangerous. However, if a trained person is driving the same car safely, it becomes very reliable. The same holds true with equity. Sure, the car can sometimes face problems like tyre burst and cause accidents. That's why there are safety features like seat belt, air bags, etc. Similarly, when buying equity you need to build in safety measures.
To reiterate this point - do not confuse between the losses due to the investor's poor investment strategy and the losses inherent in equity investment (which can be suitably curtailed through appropriate safety measures discussed later in the article).
Since the fault lies with the investor, it can be overcome only if the investor educates himself and does his own study before making any investment. This, of course, is not easy and sometimes not even feasible, given the extremely busy schedules of today's fast-paced world.
Therefore, alternatively one can look at the mutual funds to overcome this problem. (Let me caution here that putting money in a MF does not totally eliminate doing your homework before investing, but yes it does reduce your workload substantially.)
Mutual funds are;
a) managed by highly qualified and experienced professional fund managers,
b) who are supported by equally competent research analysts, and
c) are admirably regulated by SEBI and AMFI, thereby ensuring smooth and transparent functioning of the mutual funds industry.
Further mutual funds
a) offer high levels of diversification even with very small money
b) offer a very wide variety of schemes catering to almost all the needs
c) are extremely flexible
d) with high degree of liquidity and
e) enjoy a favorable taxation policy.
All this makes it quite beneficial, safe and convenient for people to invest in the mutual funds. Mutual fund is an ideal choice for an ordinary and small investor
Safety measures to reduce equity risks
Broadly speaking, I associate two types of risks with equity:
a) The business risk
What is an equity share? Share is NOT a lottery - as many presume it to be - where only luck matters. Instead, it is a share in some business. As such it is quite logical that if a business does well, its' share will also do well; and if some business fails, its' share too will lose money. Thus there is a 'business risk' inherent to the equity investment.
So how can you manage this business risk in equity? Simple...you should have more successful businesses in your portfolio than the failures. Then, despite a few failed businesses (and consequently their shares), in totality you will make money.
As mentioned earlier, this diversification can easily be achieved by investing in a mutual fund. Even with a small investment of Rs.500-1000, you can buy into a well-diversified portfolio; whereas even with Rs.50,000-1 lakh you may be able to buy shares of, at best, 2-3 good companies.
b) The volatility risk
Another risk inherent to equity is...volatility. The business prospects do not change minute to minute. But share prices do change minute to minute. And moreover this change can, many a times, be quite sharp and swift. It is these sudden and huge price fluctuations that can unnerve even the most seasoned investors.
History, however, shows that prices may exhibit instability in the near-term due to factors, which may generally be short-term in nature.
But in the long-term, the price trend depends on the business prospects. If businesses do well, then despite short-term variations, the stock prices will end-up higher. Therefore, if the investments have been chosen well, it would be prudent to stay invested rather than let the market play with your emotions.
This is possible by treading and trading carefully...or doing what in common parlance is termed as the Systematic Investment Planning (SIP). It is same as your RD (recurring deposit) in a bank FD, which you are quite familiar with. In simple terms, SIP is nothing but making
Suppose you had Rs.50,000 and you invested it entirely at one go. Then you could experience extreme emotional distress if the markets were to fall by say 10-20%. But, if you had invested only Rs.5,000, you would not be worried too much. And since you would be in control of your emotions, you may not take any hasty and impulsive decisions that you may regret later. Thus SIP enables you to manage your emotions.
Secondly, it is common sense that you should buy low and sell high. Yet there are numerous instances where the investors do exactly the opposite. They buy when the markets are euphoric (and hence over-priced) and sell when the markets look hopelessly depressed (and hence under-priced).
But if you were doing SIPs, without bothering about market levels, you will end-up buying more units when the markets (and hence the NAVs) are down and less units when the markets (and hence the NAVs) are up. And this is exactly what one should ideally be doing. Or, in other words, you are not trying to predict and time the markets; which anyway has historically been proven to be totally futile.
Thus with SIPs, you generally tend to get a lower average cost of acquisition (known as rupee-cost averaging). It is but simple mathematics that lower purchase price translates into (a) increased probability of making money and (b) increased possibility of making more profits.
Third, it may not always be easy to make large investments. However, putting in say Rs.500-1000 per month, at the very minimum, out of one's monthly income would be quite convenient for most investors. Thus, by doing SIP you will not be putting any pressure on your day-to-day finances; nor keeping your money idle till you have saved sufficient money to buy shares directly.
a) Handing over the money to a professional fund management team of a MF makes ample sense for an average investor. In the absence of adequate expertise for right stock selection, adequate corpus for proper diversification and adequate time for regular monitoring, it would not be wise to try buying stocks directly.
b) Doing systematic investment is prudent from the point of view of
- Managing emotions
- Averaging the costs and
- Comfortable monthly budgets
The author is a personal finance advisor (www.wealtharchitects.in) and author. 'Millionaires don't eat cakes...they make them' is his latest publication.
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