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Tuesday, May 10, 2011

5 reasons why small investors should avoid stocks and buy mutual funds

Reason No. 1: Insufficient funds

Many small investors are unable to spare more than Rs 5000 or 10000 per month for investing. Such amounts are insufficient for investing in excellent stocks. Investors can at best buy only 25 shares of ITC, or 10 shares of HDFC.

Alternatively, they can buy 50 units of DSPBR Top 100 fund. The fund’s equity holdings include ITC, HDFC, TCS, Larsen & Toubro, Coal India, ONGC, ICICI Bank, Hindalco, Grasim, Bank of India, Bharti Airtel, Glaxo Pharma, Lupin, and many more stalwart stocks. 

Reason No. 2: Insufficent knowledge

Small investors have very little knowledge of how the stock market works, and what are the rules and criteria for success. They jump into the market feet first – attracted by stories of untold riches with very little effort. No wonder they end up losing big time.

Some never recover from the initial trauma, and quit the stock market for ever. Others plod along manfully, feeling happy if they can recover their losses after a few years. A handful eventually learn the ropes and end up with a decent retirement kitty.

It is much better to invest in a mutual fund, and leverage the knowledge of the fund manager.

Reason No. 3: Insufficient time

For most small investors, buying and selling stocks is a part-time activity that provides some extra money and thrills. But to become truly wealthy from one’s stock investments, one has to be engaged in it full time.

Why? Because one has to learn and monitor a variety of information – the economy, its particular cycle stage, inflation, interest rates, oil and other commodity prices, activities of FIIs and DIIs, quarterly results of individual companies, analysing annual reports, tracking promoter activities, their shareholding, and so on. Most investors have insufficient time to spare for such learning and monitoring.

The fund manager and his team get paid to do such monitoring on a daily basis. Benefit from their services.

Reason No. 4: Insufficent experience

It takes years of experience in the stock market to learn the intricacies of fundamental and technical analysis that would enable a small investor to distinguish between a good stock and an excellent stock. A good stock may give you decent returns over a couple of years and then fall from glory (think Pantaloon or Suzlon). An excellent stock – like ITC or HDFC – will provide superior returns year after year, and can be bequeathed to future generations.

Take a re-look at some of the stocks in the portfolio of DSPBR Top 100 fund (mentioned in Reason No. 1 above). That is an excellent portfolio selected by an experienced fund manager.

Reason No. 5: Insufficient risk tolerance

Almost inevitably, a stock falls in value when a small investor buys it, and rises in value when a small investor sells it. The result is usually panic, and a desperate desire to either recoup the loss or re-enter for more profits at the earliest. Without knowledge of her own risk tolerance, a small investor invariably sells too soon or buys too late.

Better leave the buying and selling of portfolio stocks to the fund manager, so you can sleep more easily at night.

Please note that a fund manager is human and can make errors in judgement. That is why it is important that you do a little research before selecting the fund you buy. Keep investing your monthly savings regularly in buying a fund through bull and bear markets. After a few years of regular investing, your investments are likely to grow considerably – and so will your experience. Then you can contemplate building a stock portfolio of your own.

Related Post:

Why building a stock portfolio is like buying a car


Jalal said...

Very Good Post for Small Investors. I started investing regularly in Reliance Growth, Tata Infrastructure Fund and Sundaram Select Midcap for three years at the same time i also learned many things slowly about the market.

Now i have lump sum amount and started slowly investing on Equities directly.

kiran said...

Did you ever made investment at mutul fund?.
I Did last 11.5 years back at Kothari infotech. Rs 36000 and brought 1000 units even today there is no break even for that investment. I never look back again at mutul fund. Same time made investment at Banking IPOs , today they are 8 folds

Harry said...

Subhankar ji, great suggestions.

I have an opposite question. When should you be in stock market and not mutual funds? I have a selfish interest in this. I have some of my money in mutual funds due to historical reasons ... I signed up for these a while back ... and never needed the money pulled out so these sat for 2-4 years. However, in a recent analysis, I see in general these have under-performed what I can do in the market. Before I decide to move some (not all) of the MF funds into stocks, I wanted to check if there is something I should be cautious about. If something is able to invest wisely in market directly (I am only 10% towards this goal of "wisely", but hope to improve), would he/she ever get into MFs? If yes, under what circumstances?

Subhankar said...

@Jalal: Thanks for your comments. You have provided a real example of the point I made in the post.

@kiran: Sorry to hear about your loss in the Kothari fund. Seems like you made a lump sum investment near the peak of the previous bull market. Good that you have more than made up with your bank IPO investments.

I have got very good returns from HDFC Prudence fund - in which I add money whenever the market is down.

@Harry: This wasn't a MF vs. stocks comparison post. Small investors tend to buy stocks without doing adequate homework, and suffer losses. Starting with MFs may be a good way to get one's feet wet in the market - before diving in.

If you have learned the art of good stock picking, why pay fees to a fund manager?