Investing in the stock market allows you to grow your wealth in a number of ways. There are a plethora of arenas in which you can invest and generate returns based on your financial goals. In that list, the top-most popularity is occupied by two commonly known investment instruments- stocks and mutual funds.
Favoured by almost all the investors seeking to generate short and long term with calculated risks, stocks and mutual funds have a bit in common but are largely different from each other in a number of aspects. As an investor, you should also know the main points on stocks vs mutual funds that will help you enhance your investing strategy. So without further ado, let’s learn the main areas of difference between mutual funds and shares.
We can guess that many of our readers are well aware of the basic definition of stock and mutual funds, however, starting with the basics will help us proceed smoothly towards the advance.
What are Stocks?
Stocks or shares are units of ownership of a company, which means owning shares will give you proportional ownership right in the company. The same also makes you a stakeholder in the company, allowing you to vote in the company’s major decisions, receive dividends, and gain/suffer loss as the company performs. Stocks are the most basic and fundamental market instruments, based on which, almost all other derivatives are made. Mutual funds are also derived from stocks, which we will discuss afterward.
Stocks or shares are broadly classified into two heads- equity shares and preference shares.
Equity Shares: These are the most known ones that are widely traded in the stock market. Equity shares are also categorized as ordinary shares and come with a number of benefits to the shareholders. Owning stocks of a company gives you voting rights, entitles you to receive dividends, etc.
Equity shares are further divided into seven main types-
- Authorized share capital
- Paid-up share capital
- Right shares
- Issued share capital
- Bonus shares
- Sweat equity shares
- Subscribed share capital
Preference shares: Unlike equity shareholders, preference shareholders do not enjoy voting rights in the company but they are given priority over the former when it comes to disbursing dividends and compensation when the company gets liquidated.
There are broadly four categories of preference shares, and each one of those is of further two types.
- Cumulative preference shares
- Non-cumulative preference shares
- Convertible preference shares
- Non-convertible preference shares
- Participating preference shares
- Non-participating preference shares
- Redeemable preference shares
- Non-redeemable preference shares
Now that we know different types of shares, it is important to note down the key features that will be helpful for our understanding of stock market vs mutual funds.
Features of Shares
- Shares (ordinary shares) are traded live on the stock market and anyone can buy or sell them during active market hours, based on the available liquidity.
- You need to have a Demat account to trade in shares. A Demat account is a repository where the shares are kept in an electronic form.
- Owning shares allows you to earn capital gains but also brings an unlimited risk of the entire capital even turning zero.
- Being a shareholder also allows you to receive dividends when the company makes profit.
What are Mutual Funds?
As the definition goes, mutual funds are a pool of funds collected from a number of investors. They are managed by professional fund managers who decide where and when to invest the funds in order to maximize profits and minimize losses. Based on the type of mutual fund, the money pooled from investors is used to buy different market securities. This also classifies mutual funds under three main categories-
Equity funds: These funds primarily invest (atleast 65%) in equities listed on the stock exchange. There are considered to be the most rewarding as well as most risky types of mutual funds as the performance of the fund itself depends on the performance of its equity holdings.
Debt funds: These funds mainly invest (atleast 65%) in fixed interest debt instruments. This is why they are more stable than equity funds and carry less risk but that at the cost of average returns.
Hybrid funds: These funds help to manage and create a subtle balance between higher returns and risks involved by giving near equal space to both equity and debt instruments.
Features of Mutual Funds
- Mutual funds are launched by asset management companies or funds houses and they are managed by professionals known as fund managers.
- You do not need to have a Demat account to invest in mutual funds as you are not actually investing directly in shares or any of its derivatives.
- You are allocated fund units proportional to your investments. The value of the units depends on the performance of the holdings of the fund.
Now let us quickly start learning the main intent of the article- difference between mutual fund and share market.
Difference Between Stocks and Mutual Funds
What Do You Need to Invest?
You need to have a Demat account to invest in shares. This is where your shares are stored electronically. You can open a Demat account with any of the brokers registered with SEBI. 5Paisa allows you to open a Demat account without any hassle and gives you the opportunity to invest in a multitude of stocks right at your fingertips.
On the other hand, investing in mutual funds does not require any Demat account. All you need to have a functional bank account and get your KYC done. 5Paisa also enables you to grow your wealth by investing in a range of mutual funds.
One of the major aspects of stocks vs mutual funds is what you are going to own. Investing directly in stocks gives you proportionate ownership in the company through which you can vote in the company’s decisions and earn dividends.
Whereas, you get fund units against the investments made in mutual funds. Although the units are based on holdings, you still do not directly own the securities in which your money has been invested.
Returns That Can Be Generated
This is the most sought after point in stock market vs mutual funds. How much return would one earn? Well, investing directly in shares comes with its own risks which are higher but the returns can also be equally commendable.
In mutual funds, however, the risks are mitigated to a fair degree. This is because your funds are managed by expert fund managers who have experience and knowledge in the stock market and other investment instruments. Mutual funds also follow a benchmark and always aim to bring more returns than the same. For example, if a mutual fund has Nifty 50 as its benchmark, the fund’s performance will be evaluated in comparison to the returns offered by the Nifty 50 index.
As said, when it comes to share market vs mutual funds, buying stocks directly brings a higher risk than allowing an expert to manage your funds. The reason is obvious- expertise in fund management. But there’s another catch to it- suppose you have Rs 5,000 to invest in a month. You know the golden rule of investment- diversification. However, with only Rs 5,000, you won’t be able to do so. You cannot even buy 1 unit of Reliance and 1 unit of TCS share together with that 5000.
So you invest that Rs 5,000 in a mutual fund, and along with you 99 other investors also invest Rs 5,000, to make a total fund of 100 x 5000 = Rs 5 lakhs. This huge fund can be used to buy a number of shares of different companies by opening the space for diversification. You are allotted units for your contribution and incur profit/loss based on the same.
Flexibility in Investment and Withdrawal
You can invest and withdraw anytime in/from stocks during the active market hours, provided that there is enough liquidity. Except for a few categories of penny stocks, all other stocks have enough liquidity so that you can make entry and exit at your convenience.
Mutual funds are also one of the most liquid investment instruments but less flexible than stocks. The Net Asset Value (NAV) of a mutual fund is decided after the market closes. The amount you have to pay for the purchase of units or the amount that you will get after making an exit depends on the NAV of the fund. The NAV of the fund does not change throughout the day, hence, you cannot make an immediate withdrawal. Also, in the case of ELSS funds, the minimum lock-in period is 3 years.
Costs Associated with Investment
Both stocks and mutual funds are inexpensive investment vehicles when it comes to the charges that you have to bear. Stocks, however, are more cost-efficient than mutual funds. While investing in shares, you have to bear mainly the brokerage fee which is almost negligible if you are not a day trader. There are other costs as well like STT and SEBI fees, both of which are almost next to nothing.
Mutual funds, since they are managed by a fund house, come with a bit more costs than stocks. All the mutual fund costs are summed up into the expense ratio, which is actually the fee that you pay to the fund houses against the costs incurred in management of the fund. Some mutual funds also charge an exit load for early withdrawals.
Investing in stocks attracts taxes based on the types of gains made. Gains made from equity investments are broadly classified into short term and long term capital gains (STCG and LTCG) and are taxed accordingly. This is the same with mutual funds as they are also capital assets. The STCG tax on equities and mutual funds is 15%. On the other hand, LTCG of up to Rs 1 lakh on equity and mutual funds are exempted from taxation, and gains made above that are taxed at 10%.
For equities and equity mutual funds
STCG: If the investments are held for less than 12 months
LTCG: If the investments are held for atleast 12 months
For debt funds
STCG: If the investments are held for less than 36 months
LTCG: If the investments are held for atleast 36 months
When it comes to tax savings, investments made in equities cannot be claimed as a deduction. Same with mutual funds, except for ELSS funds, which allow you to claim a deduction of up to Rs 1.5 lakh for investments made in a year.
So what should you choose? Stocks or mutual funds? The answer is not in binaries. As a sound investor, you should do efficient asset allocation across different types of investment instruments including both stocks and mutual funds. If you are new to investing, mutual funds are the best to kickstart your investment journey. When you gain a fair knowledge about how the market works, you can include stocks as well to enhance your returns in the long term.