Most people who are not familiar with the investment world often get confused between Stocks and Mutual Funds. There is a fundamental difference between both these investments. Before getting into their differences, let us try and understand what these terms actually mean.
What is a stock?
A stock is a type of security that signifies a small portion of ownership of the company, this is why they are also called shares. Shareholders are part owners of the company and have a claim of the assets of the company.
Investing in the Stock Market
This kind of investment involves directly investing in the stocks of a company. You purchase stocks of the companies listed on stock exchange and earn profits from market volatility and the price of the share going up since the time of purchase.
What is a Mutual Fund?
A Mutual Fund is an investment vehicle that pools in money from a number of people to invest in securities like stocks, bonds, corporate debt instruments, and other money market instruments. Mutual Funds are managed by professionals called Fund Managers. Fund Managers structure the investments of the fund in a manner to match the investment objectives of the fund that have been mentioned in the mandate of the fund.
Investing in Mutual Fund
Mutual Funds can be invested in either directly or indirectly. Since January 2013, all Asset Management Companies (AMC) have been directed by the Securities Exchange Board of India (SEBI) to provide investors with both Direct and Regular Mutual Funds.
Direct Mutual Funds: Direct Mutual Funds are provided directly by the Fund House/AMC to the investors. There are no intermediaries involved and, therefore, no commissions need to be paid to a third party. The absence of commissions allows these funds to carry a 1% lower expense ratio, which translates to a 1% increase in returns for the investor.
Regular Mutual Funds: Regular Mutual Funds are bought through a broker or agent. The broker/agent provides investors with professional advice and helps the investor procure the Mutual Fund. As there is an intermediary involved in this transaction they need to be paid a commission. This commission is paid by the AMC to the broker and the fee is added to the expense ratio of the fund, increasing it by 1%. The increase in the Expense Ratio has detrimental effects on the Net Asset Value of the fund and can negatively affect returns to the investor.
There are 6 fundamental differences between Mutual Fund and Stock Investing;
VOLATILITY: Investing in stocks exposes the investor to market volatility directly. As the market price of the stock moves up and down due to rallying in the market the investment is directly impacted. Most stock traders mitigate volatility through diversification. Diversification is the act of making multiple investments in stocks of different companies from various industries so that volatility associated with stocks of a particular industry or company is balanced out.
Mutual Funds are a basket of securities i.e. they invest not just in stock, but in a number of securities like corporate debt, bonds, and other money market instruments to mitigate the effect of volatility on the fund. This diversification of investments can also provide investors good liquidity and regular income through interest.
RISKS AND RETURNS: Investing in stocks carries are considered riskier than investing in Mutual Funds. Stocks are highly volatile in nature and it requires a good knowledge of the market to make a successful portfolio. Even though risks are high, a well-managed portfolio can reward the investor handsomely.
Mutual Funds are professionally managed baskets of securities. These funds are designed for various purposes depending on the investors’ goals and risk appetite. Even Mutual Funds that are considered high-risk are less risky than volatile stocks, this is because they are professionally managed and include a portion of debt and other money market instruments to mitigate risk. Small-Cap and Mid-Cap Equity Mutual Funds usually produce the best returns for investors are they invest in the highly volatile small-cap and mid-cap segment of the market. The risks associated with these market segments are mitigated to a large extent by the Fund Manager who carefully selects the basket of stocks to invest in.
TAX IMPLICATIONS: Stocks carry no tax benefits for investors. The tax implications on returns from these investments range between 10% to 15%.
There is a 15% tax applicable on short-term capital gains above Rs. 1,00,000 and 10% on long-term capital gains above Rs. 1,00,000.
Whereas, if you happen to invest in Tax-Saving Mutual Fund schemes like ELSS, they allow you to deduct up to Rs. 1.5 lakh from your taxable income under Section 80C of the Income Tax Act. These funds carry a mandatory lock-in period of 3 years, but this is good, as most of these funds perform best in 3-year investment cycles.
Moreover, for as long as you are invested in the fund, you need not pay any taxes if the fund happens to sell any stock from the portfolio.
MARKET MONITORING: Investing in the stock market is a time-consuming task. It requires your dedicated attention and a lot of time to monitor market trends and fluctuations. Stocks are usually managed by the investor themselves and are not professionally managed, therefore, increasing the risk to the investor. Moreover, since the market is quite volatile, it needs to be constantly monitored to mitigate losses and take advantage of opportunities arising.
When it comes to Mutual Funds, the fund is managed by a professional Fund Manager who does the monitoring thing for you. The fund manager takes decisions regarding selling and purchasing of funds with the investor’s consent.
SYSTEMATIC INVESTMENTS: Mutual funds come with an excellent method of investment, the Systematic Investment Plan (SIP) which is a smart solution for people with busy lives and have multiple things on their list. SIP allows you to make pre-determined investments periodically, by linking your bank account. A SIP deducts a pre-determined amount from the investor’s bank account towards a specified Mutual Fund periodically, this makes investment automated and helps the investor with the discipline of investing.
There are no Systematic Investment Plans for stocks.
DIVERSIFICATION: Stocks can provide great diversification across market segments and industries, but finding the right balance is very hard.
Mutual Funds have a mix of debt and equity to mitigate risk through diversification. The securities in a Mutual Fund are carefully selected by a Fund Manager to mitigate risk and maximize returns. Depending on the investor’s risk capacity there are a number of funds with varying levels of risk.