When making investment decisions, investors often face a dilemma: whether to invest directly in shares or via mutual funds? For new investors, the benefits of investing in mutual funds outweigh the benefits of investing directly in equity. The various benefits include:
Economies of scale in purchase/transaction costs: Fund houses generally buy and sell shares in large quantities at once; hence, a per-unit price is much lower than buying shares directly.
Risk diversification: It is an essential benefit of investing in mutual funds. It helps you diversify risk, as it invests in a relatively diversified portfolio of stocks across various sectors. If you could do this by direct equity, the capital required would be huge.
Exposure to higher stocks: This is a continuation of the above point. If you were to buy an increased number of shares, the capital outlay required would be huge. On the other hand, you can get exposure to an extensive portfolio of stocks by investing as low as Rs. 500 (Rs. 5000 for some funds). This is one of the significant advantages of investing in mutual funds. For example, exposure to a stock of 3M would require you to invest Rs. 25,000; however, if you invest in a pure industrial sector fund or any other mid-cap fund which invests and has a high allocation towards 3M, you would be able to take that exposure for as low as Rs. 500.
Tax efficiency: This is only applicable to debt mutual funds. If you hold debt funds for a long term (holding period more than 3 years), the capital gains are taxed at 20% with indexation. As indexation (due to inflation) is factored in long-term, capital gains tax is reduced considerably. This is more beneficial for people who have a higher tax bracket, as they can at least reduce the tax paid under the head income from capital gains.
Professional management: Mutual Funds are managed by experienced fund managers who have the knowledge and the expertise of the market and can analyse the market conditions to time the market correctly. Timing the market means buying and selling shares at the correct time. Moreover, they are also an expert in analysing the stocks fundamentally.
High liquidity: Mutual funds are much more liquid than other investment products like equity, debentures, and other products like gold and deposit products (excluding bank deposits). Fund houses allow the investors to redeem their units at any time if it is an open-ended mutual fund. Moreover, the procedure of redemption is pretty standardised across all mutual funds. Now, what is the difference between open-ended mutual funds and close-ended mutual funds? The main difference is that you cannot redeem the funds in a close-ended mutual fund before the expiration date. However, you can sell it to a third party via exchange (if the facility is available) or via a contract. In an open-ended mutual fund, you can redeem your funds at any time, and the mutual fund pays from its pocket.
Various modes of investment: They offer investment modes like systematic investment plan (SIP), systematic transfer plan (STP), systematic withdrawal plan (SWP) and lump sum. We will be writing a different article on a detailed explanation of the working and benefits of SWP and STP.
Disciplined investing: When you invest directly in equities, you may make mistakes in buying at a high price and selling at a low price in a short period. This generally leads the investor to incur losses. However, mutual funds encourage investors to invest over a long time, essential to creating wealth. Furthermore, systematic investment plans encourage investors to invest in a disciplined manner to meet their long term financial objectives. Many investors fail to build a substantial investment corpus because they cannot invest in a disciplined way. Savings not invested regularly often gets spent on discretionary lifestyle-related expenses. Systematic Investment Plans (SIPs) in mutual funds help investors maintain a disciplined approach to savings and investment. SIPs also help investors take emotions out of the investment process. Investors often get very enthusiastic about bull market conditions but get nervous in bear markets. It is a fact that investments made in bear markets help investors get high returns in the long term. By mechanically investing through SIPs, investors can stay disciplined, critical to achieving their financial objectives.
This article discussed the key benefits of investing in mutual funds versus directly in shares. While investing directly in shares has its advantages, the benefits of investing in mutual funds outweigh that of investing directly in shares, especially for new investors. If you have expertise in picking stocks at the correct valuation, you can invest directly in shares. However, if you lack the expertise, investing in a mutual fund is a much better option.
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