Personal Finance

Index funds vs direct stock investing

B. VENKATESH | Updated on June 30, 2012

Many of you who invest in equity buy stocks directly. In this article, we discuss why you should consider buying index mutual funds instead. Our argument applies to you whether you are a mass-affluent investor or a high net worth individual (HNWI).

Indexing benefits

The amount you invest in equity is also related to your income stability, not just to your level of income.

That is, you cannot take more risk just because your income has increased over the years. Your income may be unstable if you are more likely to lose your job than before. Suffice it to know that you should moderate the risk associated with your equity investments if your income is unstable. One way to do so is to buy index funds. Why?

Index funds, as the name suggests, invest only in the stocks that constitute the index. Such funds carry only market risk.

That is, index funds will lose value if the index loses value. If you were to buy stocks directly, you take on additional risk. Why? The stocks that you bought will move up if the index goes up. But you bought the individual stocks because you wanted to generate returns higher than that of the index.

The problem is that you cannot always generate higher returns. Worse still, you have a high risk of picking an underperforming stock!

So, why not directly buy stocks that constitute the index to minimise the risk of underperformance? Mutual funds require low initial investment. You can buy units in most funds for Rs 5,000. You cannot buy too many shares with that money! For those of you are HNWI, it is easier to manage an index fund than 50 different stocks in the same proportion as the Nifty Index.

Direct investing issues

Investing in individual stocks requires you to dedicate more time and effort compared to buying units in mutual funds. This is because you have to decide whether to hold a stock or sell it when it declines or moves up sharply.

It is moot if you will be able to dedicate the required time and effort. A professional manager will manage the portfolio if you invest in a mutual fund instead.

Now, you may prefer to hire a private wealth manager if you are an HNWI. We think you should still consider buying index funds for your core investments and hire a private wealth manager to invest in products and strategies that are not available through mutual funds. Why?

Because index funds will allow you to participate in the equity market for a low fee— you pay about one per cent of your total investments.

Then, there is the psychological factor. Some of you are likely to watch individual stock price movements on a daily basis.

The more you watch your investments, the higher your anxiety levels will be. And higher your anxiety levels are, more irrational your decisions will be!

That is, you may end up selling your profit-making shares too quickly or perhaps, hold your loss-making shares for too long. You cannot do likewise with your units in mutual funds; for most funds charge a penalty of one per cent if you sell your units within one year of investing.

This will dampen your enthusiasm to sell your mutual fund units frequently.

Conclusion

You should care more about your standard of living than about your portfolio wealth. This implies that you stop chasing returns and start investing to achieve your goals, goals that will help you accumulate wealth to meet your future consumption needs.

Your objective should be to create investments that are in sync with your ability to take risk.

It is in this context that we want you to consider index mutual funds, instead of direct stock investments.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investorlearning solutions. He can be reached at enhancek@gmail.com)

Published on June 30, 2012

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