Trading v/s Mutual funds and mutual funds in depth

In this article I am going to discuss about trading, speculation, investment and finally many relevant details about mutual fund investments.

Stock trading

Let me start with explaining a little about how stock market works. Suppose I have an idea about starting a business which will be the next big thing. To execute it I would need money to fund various activities like for office space, paying salary or buying raw material or some service. I can invest my own savings, ask my friends or family to invest, go to a bank to take loan, approach some venture capitalist or angel investor. Once the business is setup and becomes successful it would require a lot more money. Then I need to go to general public and many financial institutions to seek funding. I would issue them shares which would represent their stake or ownership. If my business succeeds further, they would make money.

Stock market provides interface for this. I need to approach an stock market (like NSE or BSE) with my detailed business plan and they would facilitate the initial public offering or IPO to sell my shares at a price fixed by me. Whatever money is raised in this process would be given to me and shares of my company would be issued to those investors. Then onwards share of my company would get listed and those investors would be able to buy and sell my shares through stock market.

Once stock is listed, price would be determined purely based on demand & supply of shares. That means if business makes a lot of money & becomes successful, many people will want shares and prices will increase.  On the other hand, if business doesn't do well, people would want to sell shares and price would decrease.

However it doesn't always work that way. Not everybody would be as rational and many would simply buy and sell without much logic. Sometimes they may ignore my shares completely, despite of my business making money or want to buys shares even if business doesn't make any money. Take Microsoft and Amazon for example. Microsoft makes a lot of money (many billions of profit every year) but stock market perceive that there future is bleak and the share price goes nowhere. Whereas despite of making a little or no money, Amazon rises like anything possibly in the anticipation of huge growth in future.

Investment v/s speculation

Determining how the business behind  a share is doing and predicting it's future prospects requires a lot of knowledge and effort. Most people do not have time, patience  and interest to learn and keep track of all this. When somebody lure them to trading, they depend on tips regarding when to buy and sell. In most cases that's the worst thing one could do with his hard earned money. It's not much different than speculating on a lottery ticket or horse race.

Unless there are definite strategies to protect against losses, what you are actually doing is speculation. I find people often trading futures, options and commodities. Tell me how do you predict whether prices of copper or mustard will increase or decrease over next few months? Mostly probably you can't and same will be the case with most people. However many still speculate on commodity trading.

To sum up, in my opinion regular investors like you and me should keep ourselves away from commodity trading or trading shares, futures, options etc so that we do not indulge in speculation and put our hard earned money at risk.

Time tested strategies of investing:

• Keep realistic expectations: It's temping when we hear stories about people doubling or tripling money on certain stock or real estate. However that doesn't happen to everybody and there are many more people who in fact loose in the very same avenues. Hence consider yourself lucky if you make 100-200% gains but the chances are that over the long term equity would provide you 12-15% returns which is still much more compared to other fixed income avenues.

• Play to win in the long term: Equity could be very-very risky for short term. Unless you are willing to stay put for 10-15 years or more, chances are you might loose a lot of money in equities.

• Know what you are doing: This is the most important thing. You must understand precisely why you are choosing certain investment avenue so that you can keep a tab on your investments and take corrective actions in case something goes wrong.

• Diversification: do not put all eggs in the same basket. In case something goes wrong with one investment and you loose money on it, gains in the other can compensate for the same.

• Rupee cost averaging: economies and markets see many ups and downs over the time and it's not possible to predict accurately when market is at absolute low or high. Hence it make sense to invest fixed amount every month so that the price averages out and we make better than average gains.

• Asset allocation: neither invest all of the money in equity nor in debt. When people are young, they can afford to invest larger portion in equity as they can stay put for longer time. The older they grow, they can gradually move it in debt. Thumb rule is to invest %-age of money equal to your age in debt and rest in equity. So a 30 years old invests 30% of his savings in debt and 70% in equity. Then one should keep reviewing the portfolio periodically and rebalance accordingly. This way when stock markets move up you will automatically move some money in debt and vice-versa to gain from market movements without timing the market.

Mutual funds:

Mutual funds receive money from people like you & me and invest it into multiple shares hence offer much better diversification. They hire one or more dedicated professionals called fund managers, with education and experience in equity research to do that job. Fund managers have skills to select right businesses to invest and track developments to make informed decisions regarding when to buy and sell. 

Mutual funds provide opportunity for all investors to take exposure to equity while minimizing risk with diversification and rupee cost averaging through SIPs.

Types of mutual funds:

• Equity oriented: these funds invest major portion of their portfolio in equity shares of various companies. They are tax efficient as gains made for period more than 1 year are tax free.

• Debt oriented: these funds invest major portion of their portfolio in various debt options like corporate deposits, government securities etc. They offer low returns compared to equity oriented mutual funds but are much less risky and tax efficient than bank FDs & corporate deposits.

• Hybrid: They offer somewhat middle ground by investing portions of portfolios in both debt & equity. There are Hybrid equity oriented or balanced funds that invest about 65% of money in equity. Hence they offer good returns compared to debt funds. At the same time risk is much lesser compared to equity oriented funds that invest 90% money in equity. Best part is that these are treated like equity funds and returns over 1 year are tax free. Then there are Hybrid Debt Oriented funds which invest some 10-15% portfolio in equity hence offer slightly better returns than debt funds.

• Sectorial funds: These are like regular equity oriented funds but they invest in only companies of certain sector say banking or IT. These are far more risker compared to diversified equity funds and unless you can predict which sector is going to outperform others, your investments would be at huge risks. These must be avoided by regular investors.
• Large cap/Mid-small cap: Shares of small companies have greater potential to gain because if small company does well and end up becoming huge overtime, investors of those will get huge returns. But as you might have guessed, risk of loosing money is far higher as many small businesses will eventually fail. Hence small and mid cap funds strive to gain more by taking more risk. Larger companies are more stable but they have limited growth potential. Hence large cap mutual funds which invest primarily in those bigger companies offer lesser return with lesser risk.

• Equity tax saving (ELSS): These are similar to equity diversified funds with lock-in period of 3 years and you can invest upto Rs 1 lakh to get tax benefit under 80C (more details in my previous post).

Selecting mutual funds:

Since not all mutual funds do well, it's critical that you identify best mutual funds to invest in and keep a tab on it's performance over time. In my personal experience, I saw that in 2006-07 timeframe, SBI mutual funds were doing really well. Than Reliance & HDFC funds seemed to do better. Now a days I see that most ICICI funds are doing better than others.

Hence we should be able to select winner and then review in every 3 to 6 months to ensure that they are still doing well. Else we need to switch to another good fund if our winners seem to loose out.

Can we select a mutual fund purely based on it's returns? No. Because chances are that fund might gain by investing in too many risky stocks. It might have been lucky to make huge gains in that timeframe but it's luck might run out next time. And don't just look at past 2-3 years returns as fund may not have seen enough economic cycles in such a less time. Prefer long term history over 5-10 years. 

Also keep in mind that funds return may not be much meaningful in isolation and you should always compare it with other funds in the category and general market. For example in last 3 years, market in general hasn't moved up much so most mutual funds have bad returns in that period. Then there are other parameters like beta to measure risk and alpha to see how fund generated returns compared to market.

All of above might sound too complicated again for regular investors. Hence I recommend taking a look at funds rating available at valueresearchonline.com. They rate fund between 1-5 stars, where 5-star is highest rating. While coming up with this rating, they account for risk adjusted return over a long time. I realized most funds which have good long term returns, low beta, high alpha and did better compared to benchmark & similar funds, had good rating too.

My thumb rule is that I strive to  keep investing through SIP in 5-star or 4-star funds. If it’s rating drops to 3-star, I switch my SIP into some other better fund. If rating remains at 3-star for extended period like 6 months to 1 year or drops below 3-star, I switch all my investment from that fund to a better fund.

But which type of mutual fund should I invest in:

First of all determine how much money you can invest every month which you may not need in next 10-15 years. This money could then be invested in a few good mutual funds from different categories and companies based on your asset allocation.

Suppose you can invest say Rs 10000/- every month. It would be a good idea to divide this money in 5 chunks of Rs 2000/- each. Now first SIP could be for Rs 2000/- in an equity oriented balanced fund like say

HDFC Childrens Gift Inv or ICICI Pru Balanced. 2nd SIP for Rs 2000/- could be done into a good Equity: Large Cap fund like Franklin India Bluechip. 3rd SIP could be done in a fund from Equity: Large & Mid Cap category like Quantum Long Term Equity and 4th from Equity: Mid & Small Cap fund like ICICI Pru Discovery. Finally 5th & last SIP could be in Hybrid: Debt-oriented Conservative fund like Birla SL MIP II Savings 5.

This portfolio would provide ample diversification amongst fund categories and fund houses. About 40% of it is in large & large-mid cap which provides stability with high returns, 20% is in mid-small cap that provides very high return with high risk, 20% each in hybrid equity & debt fund which provides stability with low returns. In 20 years this portfolio is expected generate wealth of about Rs 86 lakh assuming moderate return of 12% or Rs 1.22 crore at 15%.

If you are not willing to take much risk initially or want to get a feel of this process, I would recommend to start with a equity oriented balanced fund and start an SIP for few months and observe it.

For tax saving investments please see details in my previous post. Preferably  plan SIPs in them inline with your overall investment strategy. For example as ELSS do similar investments as equity diversified funds, you can swap either  Equity: Large Cap or Equity: Large & Mid Cap  with ELSS.

I hope this would have given you idea about how to select good mutual funds while  achieving diversification. In subsequent article on financial planning, I would touch upon how to plan mutual fund SIPs in order to achieve certain financial goals.

Where to search:

I use www.valueresearchonline.com. Go to www.valueresearchonline.com/h2_cat_5Years.asp, there are links for different categories of funds along with return information. For example  the link for 

Equity: Large Cap. You can sort by rating, returns etc and make a choice.

How to invest:

You need to be KYC complaint by providing details like address proof, ID proof and PAN card before you could invest in mutual funds. You need to approach a fund house (or AMC like HDFC mutual fund or Quantum mutual fund), distributors like various banks or online providers like www.fundsindia.com or registration agents like CAMS or Karvy. They will help you file for KYC, make investments, start SIP or redeem your units etc. Here are the details of these options:

• fundsindia: I use them because they do not charge up front fee and it's much convenient. You can open account in matter of days (including KYC) and start investing. You can do everything online including starting/stopping/switching SIPs, making new investments, redeeming your investments etc. They are safe and secure and I am using them for last 5 years. The only drawback is that I can't avail direct option hence my mutual fund pays them about 0.5%-1.5% yearly as trailing commission which is very less price to pay in my opinion for the convenience that they are offering.

• Banks: generally all banks distribute most mutual funds and you can fill up application form by visiting bank branch. They charge 2-3% upfront fee for every installment of SIP and get trailing commission too. This would be a bad option in my opinion.

• AMC or fund houses directly: You can visit their office and some of them provide option to invest online. For me it's a hassle to keep track of all those passwords and investment details separately and I prefer fundsindia.  Only positive point is that I could avail direct plan of mutual funds in which trailing fee could be saved.
• Transfer agent (CAMS or Karvy): they offer services like AMC only but you can invest in almost all mutual funds from 1 place. Still you need to visit them every time to make investment and manage your investments separately for all mutual funds.

Disclaimers and disclosures:

The views shared here are based on my own knowledge and research. Whatever advise I am offering here is best based on my own knowledge & abilities. I would like to reiterate that equity investments are risky and there are no guarantees. However avoiding equity completely is riskier. The risk associated with them can be managed and that's what I am trying to put it across in simplest possible terms. More on this here.

I am not going to get any commissions from any mutual fund etc in case you act on my advice and I don't take any legal responsibility for any losses that you might incur (at the same time not asking you to share your gains with me :P). 

I am recommending fundsindia because I am using it for last 5 years and I found it really good and convenient. I am just another user for them and I would NOT be getting any commissions on any investments that you are going to make. If you use the link above to register, I might be getting a Rs 200/- coupon one time in case join them. However that is not my primary motivation and I have made my family & close friends join fundsindia even before they started any such campaign.