Why you must be in direct equity

In several of my blog posts, particularly in the series “Equity as an asset class”. I have explained the need of investment in equity. To restate the argument in simple terms, returns from equity and Real estate are the only ones having the potential to beat inflation over the long run. Given that RE investments are complex to both buy and sell and need a fair bit of money at one go, investment in equity is an obvious choice. The next question is what should be the investment vehicle for equity investments. Mutual funds and stocks are two of the possible vehicles that you can go for.

For most people who are investing today, Mutual funds are the preferred route of investment and I think this is a good idea. To begin with the investor is unaware of the complexities of the market and investment in MF is a safe way to start. Regular investment through SIP is also a good idea as long as we understand the limitations of SIP as an investment mode and have taken care of those. I have explained this in some detail in the last few posts of mine in this blog.

In this post I want to talk about investing in direct equity. Among retail investors the practice of investing in stocks is rather low and one of the main reasons is the active discouragement that is prevalent from most quarters. We Indians have an opinion about everything, irrespective of our intrinsic knowledge of the relevant subject, and this is more so in the case of cricket, movies and the stock markets. Instead of going into a long discussion about the normal objections on investing in stocks and why they are not necessarily correct, let me simply give my personal take and example on each of these.

  • Stocks are inherently risky, you should invest in MF through SIP which has a lower risk.
    • Understand that equity MF and direct equity both have the same underlying assets and therefore carry the same risks. I have already explained in an earlier post about the limitations of standard SIP.
    • Even though you can know about the MF holdings you are in no position to decide on the calls the Fund manager takes. In direct equity you have an advantage of investing in exactly the company that you want to invest in.
    • My personal experience has been that the risks of loss is the same for both in a falling market but the possibility of greater returns is more in the right stocks when the market rises rapidly.
  • Stocks lose more money as compared to MF when there is a market crash,
    • Now, there is some truth or half-truth in this. Individual stocks can lose far more than MF in a falling market. However, the reason for it is that MF scheme is a portfolio of stocks and cannot be compared rightly with a single stock. If you are comparing a portfolio of stocks to the MF scheme the outcome will roughly be the same.
    • My experience in the 2008 crash was that both my stock and MF portfolio lost by nearly the same amounts.
  • You need to be an expert in Financial markets to invest in stocks.
    • This is simply not true, though you do need to understand some things about markets and businesses in order to select the right stocks to invest in.
    • There is a lot of good information available, you just need to use it in the right manner.
    • Most of what people will tell you about reading Balance sheets etc is actually rather limited in use. There are better people than you doing the analysis and you can simply use their work without reinventing the wheel.
    • Most of what I have learnt is on my own, without attending any workshops or similar things.
  • A Fund manager can take the right calls on his portfolio and you cannot.
    • This is simply not true as a fund manager has limited flexibility due to redemption pressures and the need to deploy money when he gets it. We as individuals are only accountable to ourselves.
    • There are many glaring examples of Fund managers having taken the wrong calls.
    • The fund manager undoubtedly has access to more resources but that does not make his task any easier.
    • My own CAGR in stock portfolio has comfortably beaten that of my MF portfolio over a long timer period.

So, it may be possible to invest in stocks but why should you be doing it. A one word answer is “growth” but let me try and give a more detailed one:-

  1. As I have said before, you need to have 3 portfolios – debt for your financial base and to ensure that you are not forced to sell equity at the wrong time, MF to plan for meeting your financial goals and Stocks, to give you the kicker returns that your portfolio needs.
  2. If you build a robust portfolio of stocks the chances of losing money is very little over the long term but the potential returns can be substantial.
  3. As a country, we are going to have a high phase of growth over the next 2 decades or so and several companies will be benefited by it. Investing in some of these companies will have potential for the investor to create serious wealth.
  4. Good companies pay significant dividends along with bonus etc and this can be a strong element in creating a passive income stream.
  5. It is tough to think of financial independence or early retirement without the returns from a stock portfolio.
  6. You need a stock portfolio even during retirement as it will continue to grow in value and pay you dividends.

I hope that many of you have now stopped wondering about whether you should buy stocks and thinking now as to how you should go about it. I will cover about how to build a good stock portfolio in the next post.

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8 thoughts on “Why you must be in direct equity

  1. Just My Thoughts On the Matter:

    1. Asset Classes Beating Inflation
    While equity is the asset class with the highest growth potential in the long run, it is not true that the other investments have no chance in beating inflation. When analyzing the list of various investment’s real returns there are only two asset classes not beating inflation: Treasury Bills and Commodities. Moreover, for the sake of diversification it is important to own as much asset classes as possible to recreate the efficient market portfolio.
    30-Year Average Annual Returns
    U.S. Large Cap Stocks: 5.97%
    U. S. Small Cap Stocks: 5.00%
    Long-Term Gov Bonds: 3.08%
    Corporate Bonds: 1.95%
    Real Estate/Single Family: 0.80%
    T-Bills: -0.87%
    Commodities: -2.90%

    2. Mutual Funds vs. Single Stocks
    I would not consider either purely mutual funds or single stocks to be the optimal choice to hold equity.
    Mutual Funds usually do not outperform their benchmark and because of their management fees, investors are getting subpar returns. Of course it is possible that you get lucky and end up having a Peter Lynch as your fund manager, but the average mutual fund in the best quartile of one year usually is not a repeat offender. Some investors even believe picking a good mutual fund is harder than picking a good stock.
    Stocks are a good investment, but behavioral biases keep investors from achieving optimal returns. The biggest problem is that most investors are under diversified. According to the CAPM, Investors are not compensated by the market for holding idiosyncratic risk and therefore should diversify it away at a low cost. Furthermore, people usually have a home country bias, which can lead to subpar returns as well.
    A good investment basis for a conservative portfolio should be an indexed fund, because it is a wildly diversified investment at a low cost. The best option is a World ETF, because it is the most widely diversified one (Vanguard World ETF has a beta of 1). An ETF is not limiting your downside and volatility (even though volatility is lower than singular stocks), but if you want less movement with the market you need to buy a hedge fund and not a mutual fund.

    3. Make A System and Stick To It
    Your article is good in bringing the average person closer to equity investments as a long term investment to fund your pension, however I would discourage people from picking stocks on their own unless they have extensive experience with investment theory. Most individual investors have behavioral biases to which they succumb and in the end making two percent less return than was achievable compounded for 40 years is a big amount. Losing two percent a year is already bad enough, but people lose a lot more by starting to speculate and executing a lot of trades. Sometimes they lose most of their portfolio. It is better just to pick one well diversified ETF and invest some money into it monthly to smooth out downs and ups.

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  2. As more and more money move to MFs, the Fund Managers have no choice but to keep buying stocks as they cannot hold cash beyond a threshold. Historically, retail interest in MFs is the highest during market booms. The boom since 2014 is sentimental rather than based on any fundamentals as the quarterly results so far have proven.

    As is the case with any economic transaction, ensure you get value for money before you part with it. Only then would your investments grow. One cannot expect above average returns on investments made at fancy prices.

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  3. Sir,
    can you please explain with example of the below statement:

    “Most of what people will tell you about reading Balance sheets etc is actually rather limited in use. There are better people than you doing the analysis and you can simply use their work without reinventing the wheel.”

    Like

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