Ladder7 Financial Advisories

Should You Invest in Direct Equity Instead of Mutual Funds?

There is a strong conviction among investors that investing directly into equity is going to offer them extremely high returns. There is also an equally strong opinion that Mutual Funds offer decent, though comparatively modest returns – especially compared to direct equity investment.

Written by Suresh Sadagopan

We would be seeking to find the truth about these convictions, by examining the facts here. To get to the bottom of this, we need to understand customer psychology and how they look at returns, how they project their investment successes, how they selectively remember certain stocks where they got the highest returns and talk only about that, don’t understand how compounded annual growth works amazingly in their favour, especially over long time periods.

Financial decisions sometimes transcend the rational & enter the behavioural domain.

Let’s examine.

The Thrill of Betting

When one invests in stocks and follows that day on day, it is not an investment. It is an obsession. Many don’t even do it for returns and it is done more for seeking the thrill of betting & winning. Investors are looking for excitement with their money & look at it as a way of somehow “actively managing” their money. This certainly is not something any Financial Planner/ advisor would suggest.

Some stocks do well in a certain period and they revel in the moment of that heady sensation. When stocks do badly, they re-badge them as “long-term investments” and relegate it to the background eg. Reliance Power. We need to truly ask ourselves whether seeking thrills with our money is the right thing to do.

First among Equals

People believe that they can bet against millions of other investors ( which includes Institutional investors, professional fund managers, professional investors, etc. ) and still win. These retail investors largely depend for information on TV channels, newspapers & media, their brokers & sundry others to feed them with investment candidates.

The stocks they buy are based on what is recommended by “experts” on media, solid blue-chips ( like HDFC Bank, Infosys etc. ), broker tips, self conviction that some companies will do very well ( like Gillette should do very well as it sells blades to virtually every male ) & other sources like SMS tips! They believe that by doing all these they would somehow outsmart everyone else and win!

Well-thought-out investment & Diversification

A professionally managed portfolio is put together in a premeditated manner. The candidates are chosen based on certain investment philosophies or mandates chosen, will apply filters based on numerical parameters, apply qualitative parameters like management soundness & vision, sector/ company stability, research capabilities, long-term outlook, etc. A portfolio thus put together would be a well-diversified carefully thought thorough portfolio.

In direct contrast to this, a retail investor buys blue-chip companies they love ( like HUL ), companies which the media experts, SMS tipsters & brokers suggest, the companies they read about, the companies whose products they consume, companies in which they or their friends work, etc. In short, these are companies they are familiar with. To compound the problem, some investors fall in love with some company/ sector & accumulate large stakes, which skews the portfolio

All in all, the portfolio of most retail investors are a ragtag bunch, with no underlying rationale and poor diversification.

Fast & Loose Style

Investors are a temperamental lot. Plus, they have a million demands on their time. Investors hence keep monitoring their stocks very vigorously, for a time. They let go of the reins at times, usually when the stocks are down or the markets are listless. They tend to again eyeball the stocks when the rally starts & follow it like a bulldog. This kind of pattern in portfolio management, along with the atrocious way in which they have put together the portfolio would ensure that at a portfolio level, they are doing poorly.

This is in sharp contrast to the professional fund managers & their team, who regularly monitor the stocks in the portfolio & make necessary changes. A good professional fund manager also does not have favourites & books profit when their stated investment objectives are met and move on.

Stock Returns vs Portfolio Returns

When one invests money, the returns one should be concerned should be the portfolio returns, not returns from individual stocks. A professional fund manager is always focussed on the portfolio level returns & never about the individual component returns. He knows that every stock in the portfolio has a place and every stock/ sector will not perform well at the same time.

Retail investors are unhappy with the poor performers but hope that they will recover. They never sell stocks at a loss, hoping that it will recover at some time. Waiting for such a recovery can prove to be quite costly as they stay invested for months or years just to sell at cost or at some target price, they have in mind. On a time value basis, this is a money-losing strategy.

Retail investors have pet stocks & winners that have given them huge returns – like, say, 65% – though they may be just 5% of the portfolio & the overall portfolio returns are just 5%! The focus should actually be on overall portfolio returns & on existing stocks which don’t have future promise.

More the Merrier

Professional portfolio managers limit the number of stocks in their portfolio. It’s generally 25-40 stocks. Selection is done as per set parameters & good diversification is inbuilt in the strategy, even though it is a focussed set of stocks.

Retail investors, by contrast, have a forest of stocks, without any rationale of why it is there. We have already seen the reasons why retail investors buy stocks – they got a tip on the stock, they read about it, stock guru on media went gaga over it, they love a lot of companies they hold, etc. The typical holdings in their portfolio are above 50 stocks. Many portfolios have well over a hundred stocks. That makes the portfolio unmanageable & needlessly diversified.

Cost Savings

Investors also reckon that investing in stocks saves on costs if the strategy is to buy & hold. While this logic would be correct as compared to any managed portfolio where there are fees, the selection process itself may not be robust. This could easily result in poor & risky investments, with potential to yield but low returns.

There is no merit if one saves on cost but ends up with poor investment returns. It may have been a much better idea to have a professional to manage investments at a fee.

Investing in Blue Chips Is No Strategy

Many investors say they invest only in blue-chips & hence will get good returns. Blue-chips are mature companies that tend to be big players who have the potential to offer decent returns.

But, if that is all they are seeking, they can invest in Index funds/ ETFs at very low cost. They will get exposure to blue-chips, with proper diversification & very good returns, in view of the spread. They need not go through the trouble of maintaining a bluechip portfolio by themselves.

You Make More Money by Investing in Stocks

As we have seen before, some stocks in the portfolio offer very good returns. But, it is only some stocks. The overall portfolio return is what we should be concerned about. The overall return from an equity portfolio of an investor is seldom better than a managed portfolio by a professional fund manager, in spite of the fees. This is a big myth which investors are labouring under.

As a Financial Planner/ Advisor, we have always maintained that investing through managed funds is a far better option, as compared to direct equity investments. It’s an interesting quest though, which lots of investors would want to continue – truth be damned!