1. Stocks vs Mutual Funds: Which is a better bet?

Stocks vs Mutual Funds: Which is a better bet?

Investing is basically the art of buying assets which are at a discount to their intrinsic value and selling them when they become expensive. This activity involves a difference of opinion with the seller when one is buying and the buyer when one is selling.

Published: April 11, 2017 11:22 AM
Both these attributes require a fair amount of preparation and conscious effort. Wise and distinguished investors have stated that these are life-long activities that need careful nurturing.

By Ramnath Venkateswaran

Investing is basically the art of buying assets which are at a discount to their intrinsic value and selling them when they become expensive. This activity involves a difference of opinion with the seller when one is buying and the buyer when one is selling.

Hence, the longer-term success of an investor depends on two critical factors: (1) have a better understanding of the asset compared to the average market participant(s)—essentially involves basic accounting, mathematical and valuation skills; (2) behave differently than the average market participant(s)—involves avoiding widely prevalent behavioral traits.

Both these attributes require a fair amount of preparation and conscious effort. Wise and distinguished investors have stated that these are life-long activities that need careful nurturing. Mutual funds, which employ professionals who specialize in such skills, are much better placed compared to average investors in exhibiting these traits and are better placed to generate longer-term wealth.

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Basic financial and valuation skills
Key capabilities that need to be developed for assessing an asset are:
(1) basic accounting skills, which help understand financial statements and key financial ratios to assess the health of a company. An investor can attempt to at least gather the historical financial data on his companies of interest.
(2) Read up on the annual reports of companies, note down the key takeaways and look out for any red flags.
(3) Always invert your financial decisions, e.g. in case one buys a particular stock and expects to make an X% CAGR over the next five years, will that market price make rational sense at that level? Will the incremental market capitalization be driven by cash flows from existing businesses or involve new income streams or will it be led by higher multiples ascribed by markets?

Basic behavioral tendencies to avoid
Human beings have a tendency to be comfortable in a group, act and think alike. This may be explained by our genes—our forefathers lived in fairly hostile environments, being in a group provided them necessary protection against physical harm and was a necessity for them. However, this is a trait that can be quite harmful in financial markets. Investing hard-earned money based on hear-say or an interview of a ‘market expert’ without independent reflection can result in serious financial harm. Developing a true insight on a company and assessing the probability of success requires careful examination.

Most of the opinions voiced by one’s acquaintances are not based on thorough study or sound logic and a moment’s reflection can lay bare their recommendations. Implication for investors is that one should avoid acting on tips and never allow others to do the thinking on their behalf. An average investor without the requisite training is likely to fall prey to such market tendencies, which can imperil his financial health.

One of the insights from behavioral finance is that losing Rs100 is nearly twice as painful as gaining Rs100. This corroborates with our personal experiences— we remember the harm that somebody has caused us rather than recall the many generosities someone has extended to us. Since, the market movements in the short term are fairly random, probability of upside is equal to the downside in short time periods. Constant viewing of prices will show almost equal number of periods when the price moves downwards as it moves upwards. The periods of downside are likely to cause more emotional pain than the pleasure that one gains on account of a similar upside.

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Normal human behavior will be to reduce this emotional pain and sell during one of the periods of downside. Amateur investors tend to follow the herd, which typically leads to poor investing results.
Diversification in financial markets is an under-appreciated virtue, which helps spread risks in the event some of the expectations are not met. Individual investors do not exhibit this trait and generally follow a very concentrated portfolio, which can be financially imprudent in the event of unexpected developments in the markets.

Conclusion
Consistent effort on acquiring basic financial and valuation skills while at the same time overcoming basic human tendencies (easier said than done) have historically proven to be rewarding. Mutual funds with dedicated team of professionals are better equipped to deal with the technical aspects of financial markets and also display better control against common behavioral errors as highlighted above. Hence, an average investor has a higher probability of wealth creation by investing in a MF than investing in stocks directly.

(The author is fund manager-equity, LIC MF)

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