The recipe for smart investing

Focus on building a balanced portfolio that combines the benefits of direct stock picking (potentially higher returns) with mutual funds (convenience, diversification, and tax efficiency) to create a personalised wealth creation strategy

There’s no one-taste that suits everyone’s palate. But we find that every dish has a unique taste and that could be enjoyed by many. And every recipe comes not just with taste but its benefits, suitable to most and unsuitable to a few. Similarly, every investment avenue has its unique features and benefits that suit investors. It’s about achieving the correct balance that helps in creating a good meal or investment strategy.

So, to demean a particular investment or exalt one only by its merits doesn’t help the investors completely. It’s important to build the right or suitable proportion of each of these avenues or assets to achieve the results. And so I believe there’s no bad investment at all excepting some of the phony or unregulated ones but only less-suited investment.

In a recent portfolio review, one of my clients was surprised to find the (direct) equity (stock) portfolio has underperformed the MF portfolio. Though, the MF portfolio is of multi-asset (has equity, debt, hybrid and commodities) and not a correct method to compare them. Even the equity MF portfolio has clearly outperformed the stock portfolio on one-year basis. Again, it’s incorrect to take consider a particular period to compare performances and moreover the MF portfolio had staggered additions in between while the equity had very limited additions. I’m not trying to draw any conclusions from this output to favor any avenue. What I wanted to highlight here is the expectations of the investors and the outcome of risks taken. We presume higher risk always translates to higher return.

While the goal in all investments is to generate better or higher returns and for equity investment the two common approaches is to go through direct stock investment or through mutual fund (MF) route. In the debate of stocks versus mutual funds the dilemma persists with passionate explanations on both sides of the spectrum. Make no mistake that there’s no doubt to ascribe greater benefits of substantial contributions to equities in the long run. But the mode of approach is only the moot point.

In general, the risk associated to a direct stock(s) investment grade higher than a diversified MF due to the concentration risk. Also, the MF portfolio is actively managed by a professional team, though it becomes a passive investment for the investor due to their lack of any discretion from their side. This is where the benefits dry out while a concentrated stock portfolio could generate enormous wealth if most or all the stocks in the portfolio proliferate.

For this outcome, however, requires greater diligence from the investor in the stock selection, capital allocation and time. And most importantly luck or timing as James Grant says successful investing is about getting everyone else to agree with you, later. Unless one is a skilled investor and willing to provide significant time and effort direct equity isn’t the path. Furthermore, despite the access to tools, the direct stock portfolio could experience huge drawdowns at times which isn’t easy to stomach for every investor.

For beginners, it makes sense to opt for mutual funds for their convenience, ease of execution and diversification benefits. Besides, the goal of investing their additional savings is to generate higher returns to their savings, the prospects of learnings through huge financial setbacks is not desirable. Also, the size of the capital would certainly hurt a retail investor whose ability to allocate across a few stocks is limited but could enjoy such privilege in MF even at a substantially lower quantum.

Another aspect to be considered is the taxation. MF could boost on that front as the transactions i.e., selling and buying of securities or stocks at the fund level are not taxed at the investor’s end while any reorganization of the existing stock portfolio would result in the taxation for the investor. And then the dividend angle. To benefit from the stock investments, one must re-invest the dividends received from the stocks but this is auto-accrued to the corpus in a MF.

Though, it appears as a skewed argument in favor of MF, it’s not either of the investment for wealth creation but it’s a combination of both. A rightful mixture of MF and stock portfolio could enhance wealth creation for investors in the long run.

(The author is a co-founder of “Wealocity”, a wealth management firm and could be at [email protected] )