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.

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Why building a stock portfolio is like buying a car

Which stock (or mutual fund) to buy?

"I have 2 lakhs to spare - which stock should I buy? Or, should I invest in a mutual fund?" These are typical questions I face from investors who enter the stock or fund investment arena for the first time.

May be it is not the first time. Investors may have burned their fingers in their initial attempts, and are now being cautious by seeking guidance. Either way, my answer is usually the same: If you have less than 5 lakhs and/or are not sure how to go about selecting stocks to buy, invest in mutual funds.

Should I be more 'helpful'? Should I just provide a list of fundamentally strong stocks and be done with it? Here are three reasons why I don't go down that path.

1. There are plenty of web sites, blogs and investment groups spewing out free stock 'buy' advice by the truckload every single day. Why add to the noise?

2.  The stocks I recommend to buy are the ones that are likely to make you rich slowly. They are stocks that have low debt, pay decent dividends and appear to be 'expensive'. Most new investors are interested in 'cheap' stocks that will make them rich quick.

3. This is a corollary to 2. If there isn't a substantial investible surplus, new investors usually buy a large quantity of a 'cheap' stock instead of a small quantity of a 'good' share. This quest for hitting it big usually leads to a big loss. (The fact that the Cals Refineries stock trades in such high volumes is an example.)  

With the Sensex hovering near its 52 week high for a few months and defying all attempts by the bears to engineer a correction, more and more new investors are flocking to the market with full pockets. Unfortunately, most of the low-hanging fruits have already been eaten.

So new entrants will either end up buying good stocks at inflated prices, or junk stocks that appear 'cheap'. Both are harmful to building your long-term wealth.

If you have money to spare and are not sure which stock to buy, look at an index fund or index ETF. You get to 'own' all the stocks in the index by just buying the fund units.

Better still, look at good balanced funds which can better protect the downside due to their debt component. Say an HDFC Prudence fund or a DSPBR Balanced fund that have proven performance records over the years.

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Should you invest in Balanced Funds?

Do you invest with your head, or do you invest with your heart?

One of the building blocks - may be the most important one - of becoming a successful investor is to know yourself. To help you understand if you invest with your head or your heart, here are some practical situations that you are likely to face:-

1. March is usually the time for last-minute tax-saving investments. So you start looking at some ELSS funds. You hold the SBI Magnum Tax Gain fund since Mar '07. It was one of the best ELSS funds then and gave good dividends.

Your head tells you to sell it because of its recent under-performance and switch to Canara Robeco Tax Saver or DSPBR Tax Saver. Your heart urges you to stick with it as it will surely return to its earlier glory.

2. The Nifty is trading just short of its Jan '10 high for the past 6 trading sessions. Your head is saying 'be careful' because a previous top made some time ago can be a tough hurdle to cross. Your heart is saying 'a new high is imminent' and this is the time to jump in.

3. You had made a killing in the Bharti Airtel stock when you sold part of your holdings when it hit 1200 (pre-split) back in 2007. The rest of your holding effectively became 'free of cost'. Ever since, the stock has been sliding, but you held on because your holding cost was zero.

Your head is urging you to get rid of it, as the entire telecom services space has lost its pricing power with the entry of big global players. Your heart is forcing you to hold on because Bharti has proven management and the stock will definitely move above 500 soon.

4. Your decision to pick up OnMobile Global shares at 250 in Mar '09 turned out to be a really judicious move, as the stock zoomed to hit 700. Out of the blue, the bears attacked and the stock halved in value to 350.

Your head is accepting the fact that you got a lucky break initially, but you goofed by not booking profits at 700. Your heart is considering it as plain bad luck that your smart pick suddenly changed direction through no fault of yours.

5. You read my blog post about Indraprastha Gas back in July '09 when the stock was trading at 137. I had mentioned a possible target of 180. You decided to spend some time to research the stock thoroughly. But within a month, before you could gather sufficient details, the stock hit 180.

Your head told you to wait for better valuations. Your heart decided that you should buy before the stock runs away even higher.

6. Cranes Software was a hot stock in the previous bull market. It sold engineering software products to overseas clients and made huge profits. Because of the down turn, the stock hit the skids but at 45 it seemed like a screaming buy.

Your head warned you not to try and catch a falling knife. Your heart ignored the warning as the downside seemed very limited, and you bought a large chunk and then averaged down at 30.

If you are like most investors, you some times invest with your head and at other times invest with your heart. There are no guarantees which will be a better investor - your head or your heart. Logically, for long-term investors, the head should rule the heart. But stock markets can be illogical in the short-term.

Should you invest in Balanced Funds?

As the bulls and bears continue their fight for dominance in the stock market, risk averse investors are probably having a tough time deciding what to do, and when to do it.

In this post on December 8, 2008 I had advocated periodic investments in the Nifty BeES ETF (Exchange Traded Fund) from Benchmark Mutual Fund. ETFs are bought and sold like equity shares in the stock market any time during the trading day at the prevailing price. No entry or exit loads apply, but STT (Securities Transactions Tax) is payable.

What I had not mentioned was that since ETF transactions are made through a broker in a stock market, one needs to have a demat account. Many mutual fund investors may not have - or may not want to have - a demat account.

For such investors, ETF is not an alternative. Should one invest in index funds alone? Yes, if you are a passive investor who does not like to keep track of market goings-on and do not mind waiting for a long time to get returns on your investments.

But remember that an index fund has as much risk as owning the top index stocks. If the index rises 100%, so will an index fund. But when the index falls 60%, the index fund will fall a similar amount.

If you wish to reduce risk further, periodic investments in a balanced fund could be a viable option. Why? Balanced funds are like diversified equity funds that invest a portion of their corpus in fixed income instruments. Such instruments may be fixed deposits, Govt. of India securities, bonds, Non-convertible debentures (NCD), commercial paper.

The fixed income portion can be up to 35% of the total holdings to qualify for availing short and long term capital gains tax benefits similar to a pure equity fund.

The equity portion is balanced by the fixed income portion. This reduces risk because the down side is limited by the regular earnings from the fixed income instruments in the portfolio of the fund. While the average diversified equity fund had fallen 55% in the recent bear mauling, the average balanced fund fell around 41%.

However, in a bull market, the NAV growth of a pure equity fund is higher than a balanced fund because the upside gets capped by the lower return from the fixed income portion.

So which balanced funds should you own? The two best funds in terms of recent as well as long term performance are DSPBR (earlier DSPML) Balanced fund and Magnum Balanced fund. The former has around 20% of its portfolio in fixed income instruments, while the latter has nearly 30%.

I prefer the dividend option over the growth option when investing in mutual funds. The periodic dividends are akin to partial profit booking, and provides liquidity.