One of the top most questions that comes in each
and every investor’s mind is among investing in mutual fund scheme or direct
equity, what should he or she opt for?
Let’s try to answer this question in this article.
An equity mutual fund comprises a basket of stocks actively managed by a
professional fund manager. However, it is very important for you to understand
the fact that investment in a single stock is not equivalent to that of
investing in a mutual fund. In fact, you can say investing in a basket of
stocks can be comparable to investing in mutual funds.
Before we start comparing investing in direct
equity stocks and mutual funds, one important thing to remember is that both
investment avenues have a risk element. However, mutual funds are considered
less risky compared with investment in stocks. Mutual funds provide you with
diversification across stocks and sectors. This ensures that you risk is
well-spread. When it comes to direct stocks, you might face certain limitations
simply because you may not have the required research or familiarity with
certain companies or sectors.
Mutual funds are a passive investment for the
investor, which are actively managed by a professional fund manager. However,
direct equity investment requires active management from the investor. From a
cost of investment perspective, investing in stocks works out cheaper than
investing in mutual funds. The brokerage that you pay when you buy a stock is
much lesser than the fund management fees that you would pay while investing in
a mutual fund.
Direct equity investment is well-suited to
investors who have skills and knowledge to pick stocks. Moreover, these
investors will often tend to have access to stock market research and data,
which will help in taking stock calls. More importantly, investors in direct
equity must ensure that they have the time to manage their equity investments
on a daily basis.
Most first time investors or people who are not
familiar with the stock markets generally prefer mutual funds. That said,
irrespective of whether you want to invest in mutual funds or direct equity
stocks, you can always appoint a professional stock broking agency. Some of the
major benefits of having a professional broker handle your investment include
proper financial planning, diversification strategy, timely stock market tips,
recommendations, advisory, research, and much more.
Types of risk
associated with equity investments
We so often hear about investments in equity being
a risky proposition. Before investing in any of the product one should have
enough knowledge on the financial instrument. Investing in equity comes with
risks. Have you ever wondered what
these risks are? And what are the factors affecting your investment decision in
the instrument? Risk is nothing but the
deviation from expected returns. Higher the risk, higher the returns and
vis-versa. So, risk and return are said to be inversely related. Likewise
investing in equities comes with the higher risk while investing in bonds are
considered to low risky and expected return are also less.
Here are different types of risk
associated with investment, which you need to be carefully throughout your
The country’s economy plays a vital role in
performance of financial instruments. The economic risk includes growth of the
country, inflation, interest rates, balance of payment etc. Any hindrance in
any of the sector will directly impact the financial status of the country.
This will have direct impact on the company performance, indirectly hitting
your shares and your money. So, one has to keep eye on the economy and
Exchange Rate Risk
Most of the companies revenue is dependent from
outside country especially software and import-export companies who are mainly
dependent on the exchange rate. Any fluctuations in currency will direct impact
the company profit and shares. So, people with such exposure can enter into
futures and option where they can minimize their losses by hedging.
It is also very important that how the company
manages its finances. The company’s equity-debt ratio. How the company prefers
to borrow money? If the company is highly leveraged than there are chances of
not meeting liabilities and can go bankrupt. Before investing any shares, do
look at all the possible ratios which could impact your investment.
Industry level Risk
All industries face cyclical growth. So, one should
examine the previous performance of the industry to know whether the company is
in growth phase of decline phase and invest accordingly. Any new industry
specific news will also hamper the stocks of the company. Apart from these
there are other risks like management risk, business risk, and interest rate
risk. Most of the investment risk can
be reduced by being update and the best way is diversifying your stocks into
Breaking down Private Equity
Private equity investment comes primarily from
institutional investors and accredited investors, who can dedicate substantial
sums of money for extended time periods. In most cases, considerably long
holding periods are often required for private equity investments in order to
ensure a turnaround for distressed companies or to enable liquidity events such
as an initial public offering (IPO) or a sale to a public company.
Private equity offers several advantages to
companies and start-ups. It is favoured by companies because it allows them
access to liquidity as an alternative to conventional financial mechanisms,
such as high interest bank loans or listing on public markets. Certain forms of
private equity, such as venture capital, also finance ideas and early stage
companies. In the case of companies that are de-listed, private equity
financing can help such companies attempt unorthodox growth strategies away
from the glare of public markets. Otherwise, the pressure of quarterly earnings
dramatically reduces the timeframe available to senior management to turn a
company around or experiment with new ways to cut losses or make money.
Private equity comes with its own unique riders.
First, it can be difficult to liquidate holdings in private equity because,
unlike public markets, a readymade order book that matches buyers with sellers
is not available. A firm has to undertake a search for a buyer in order to make
a sale of its investment or company. Second, pricing of shares for a company in
private equity is determined through negotiations between buyers and sellers
and not by market forces, as is generally the case for publicly-listed
companies. Third, the rights of private equity shareholders are generally
decided on a case-by-case basis through negotiations instead of a broad
governance framework that typically dictates rights for their counterparts in
While private equity has garnered mainstream
spotlight only in the last three decades, tactics used in the industry have
been honed since the beginning of last century. Banking magnate JP Morgan is
said to have conducted the first leveraged buyout of Carnegie Steel
Corporation, then among the largest producers of steel in the country, for $480
million in 1901. He merged it with other large steel companies of that time,
such as Federal Steel Company and National Tube, to create United States Steel
– the world’s biggest company. It had a market capitalization of $1.4 billion.
However, the Glass Steagall Act of 1933 put an end to such mega-consolidations
engineered by banks.
Private equity firms mostly remained on the side-lines
of the financial ecosystem after World War II until the 1970s, when venture
capital began bankrolling America’s technological revolution. Today’s
technology behemoths, including Apple and Intel, got the necessary funds to
scale their business from the Valley’s emerging venture capital ecosystem at
the time of their founding. During the 1970s and 1980s, private equity firms
became a popular avenue for struggling companies to raise funds away from
public markets. Their deals generated headlines and scandals. With greater
awareness of the industry, the amount of capital available for funds also
multiplied and the size of an average transaction in private equity increased.
Risks of investing in shares
The biggest risk of investing in shares is that you
could lose some or all of your money. It’s important not to trick yourself into
thinking that this couldn’t happen to you.
Worse still, a company could go out of business and
you could lose everything that you invested in it.
When you make investments, you should have realistic
expectations about how they might grow and what you might achieve as a result.
Set the bar unrealistically high and you’ll need to take on more risk and open
yourself up to higher potential losses.
Questions to ask yourself
How much can you afford to lose?
The price of shares will go up and down so think
seriously about how much money you could tolerate losing without it impacting
Will investing keep you up at night?
Think about how you would feel if the value of your
share portfolio fell by 10%, 20%, 30% or 50%. You should set this range for
yourself and find the right balance of investments to match your capacity for
How long do you have to invest?
Your tolerance for risk is always linked to the
length of time you have to invest. The longer you have to invest, you more able
you will be to withstand the ups and downs of share markets. If you are trying
to make short term gains, you will be more vulnerable to short term losses.
Can you afford to not have access to your money?
If there’s a chance that you’re going to need to
access your money in the next year or two, shares are probably not for you. If
the share market unexpectedly goes down in that time, will you be able to wait
for a recovery?
Risks faced by equity funds
Market risk is basically a risk which may result in
losses for any investor due to a poor performance of the market. There are a
lot of factors which affect the market. A few examples are a natural disaster,
inflation, recession, political unrest, fluctuation of interest rates. Market
risk is also known as systematic risk. Diversifying a person’s portfolio won’t
help in these scenarios. The only thing which the investor can do is wait for
the storm to calm.
Concentration generally means focusing on one
thing. Concentrating a huge amount of a person’s investment in one particular
scheme is not a good option. Profits will be huge if lucky, but losses will be
more. Best way to minimize this risk is by diversifying your portfolio.
Concentrating and investing heavily in one sector is also very risky. The more
diverse the portfolio, the lesser the risk is.
Interest Rate Risk
Interest rate changes depending upon the credit
available with lenders and the demand from borrowers. They are inversely
related to each other. Increase in the interest rates during the investment
period may result in a reduction of the price of securities
For example, an individual decides to invest Rs 100
with a rate of 5% for a period of x years. If the interest rate changes due to
changes in the economy and it became 6%, the individual will no longer be able
to get back the Rs 100 he invested owing to the fact that the rate is fixed.
The only option here is reducing the market value of the bond. If the interest
rate reduces to 4% on the other hand, the investor can sell it at a price above
the invested amount.
Liquidity risk refers to the difficulty to redeem
an investment without incurring a loss in the value of the instrument. It can
also occur when a seller is unable to find a buyer for the security.
In mutual funds, like ELSS, the lock-in period may
result in liquidity risk. Nothing can be done during the lock-in period. In yet
another case, Exchange traded funds (ETFs) might suffer from liquidity risk. As
you may know, ETFs can be bought and sold on the stock exchange like shares.
Sometimes due to lack of buyers in the market, you
might be unable to redeem your investments when you need them the most. The best way to avoid this is to have a very
diverse portfolio and making fund selection diligently.
Credit risk basically means that the issuer of the
scheme is unable to pay what was promised as interest. Usually, agencies which
handle investments are rated by rating agencies on this criteria. So, a person
will always see that a firm with a high rating will pay less and vice-versa.
Mutual Funds, particularly debt funds, also suffer
from credit risk. In debt funds, the fund manager has to incorporate only investment-grade
securities. But sometimes it might happen that to earn higher returns, the fund
manager may include lower credit-rated securities.
This would increase the credit risk of the
portfolio. Before investing in a debt fund, have a look at the credit ratings
of the portfolio composition.
Consultants Pvt Ltd