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Stocks or Mutual Funds
The average investor would do well to have his money managed by professionals in mutual funds and should invest in stocks only under specific circumstances.
My nephew is 14 years old and extremely thin: he is 6 feet tall and weighs 50 kilos. I often tell him that he should put on weight so he won't get pushed around by his bigger friends. He rebuts me saying, `They may be stronger, but I am faster. I laugh at his misplaced confidence, especially when his best friend squashes his hand in an arm-wrestling challenge in less than 10 seconds! However, my nephew's mentality is typical of the average Indian--a feeling that we are better than the rest, no matter what our frailties. I see this mentality clearly when I talk to customers who invest in direct stocks. In spite of the odds stacked against individual stock pickers, many consider themselves market professionals. I see in their portfolios a mishmash of wild guesses and speculation, rather than carefully thought through strategies. Yet, they believe that their stock portfolios will eventually perform better than a professionally managed mutual fund.
In the short term, the stock market is a zero sum game. For every winner, there has to be a loser. For each stock that you sell, there is someone willing to buy it from you. As a buyer, you make money if your stock rises in value. The seller has lost the same amount of money through the opportunity he misses. Similarly, as a seller, you make money if your stock falls in value after you sell it through the loss you avoid. This is the same loss that the buyer inherits from you. Hence, the zero sum game.
A casual investor often pits himself against professionals. I recently visited the head office of a large mutual fund company and part of the agenda was for them to showcase the investment processes they follow. The breadth and depth of information available to a fund manager at the click of a mouse is mind-boggling. He has access to all annual reports of the company, all company reports of sell side analysts covering those companies, all company visit reports from their in-house analysts, as well as publicly available information on their Bloomberg terminals.
Once these are digested and if they were still interested, the fund managers can visit the companies, meet the senior management, and understand first-hand the performance of these companies. Compare this with a tip from an acquaintance or a passing discussion on a television channel that often drives investment decisions of casual investors. It becomes obvious who is likely to end up on the losing side of the zero sum game.
So should you buy stocks? In two cases, the answer is `yes'. In the first case, let us say that you have developed a great understanding of a particular industry. Perhaps you have worked in the industry for decades and really know the companies, the dynamics and the market forces in that industry. You are, therefore, well-positioned to leverage this knowledge for investment in companies of this industry. Keep in mind, however, that you need to stay up to date on the news and events in the industry so that you can identify new ideas and exit the fading ones.
Since you are behaving like a professional investor in this case, it is important to benchmark the performance of your portfolio against, at least, the average fund manager, if not the best. The performances of various schemes are readily available in various newspapers and magazines. Be honest with yourself and look at your successes and failures. In the second case, suppose you get a real high from the cut and thrust of trading. You love the adrenaline rush of making a killing on a stock you identified early, and losing sometimes doesn't get you down too s much. You love the bulletin boards, the sharing and camaraderie that comes from sharing your experiences with other like-minded friends. Go for it, with a few caveats. First, you must decide how much you want to devote to this passion, both in terms of money and time. Second, be disciplined in terms of sticking to the rules you define. Third, recognise that emotions are the biggest enemy of a trader. So learn to manage your emotions, both greed and fear.
What if neither case describes you? In such a case, it is advisable to hire a professional to manage your money; someone who has the strengths and resources listed earlier. The good news is that it is quite easy and inexpensive to hire such a person. All you need to do is invest in a mutual fund. You pay a fees of about 2% of your investment and get the best fund managers in the country working on your portfolio.
Even the best fund managers go through their phases of underperformance. The good fund managers bounce back, but some others languish. Therefore, not only is it important to pick good schemes, but it is also essential to monitor their performance and ensure that you weed out the bad ones on a regular basis. Enlisting the help of an adviser brings two levels of monitoring to your portfolio. The first is the fund manager, who picks good stocks, and the second is the adviser, who picks good fund managers.
We have described earlier how the stock market can be a zero sum game in the short term. You could come out either a winner or a loser. However, the long term is an entirely different ball game. If you have picked the prime factors that you can count on--good fund managers, schemes and advisers--you are certain to come out ahead in this game. This pretty much sums up the mutual fund versus stock investment argument.
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