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Should One Invest In Equities Or Equity Mutual Funds?

Invest in equities or Equity Mutual Funds :

“I am a conservative investor”.

“I do not like to take risks”.

“Equities are not for everyone, definitely not for me”.

“Invest your money wisely. Don’t invest in equity”.

Do any of these sentences ring a bell? Do you also belong to the same school of thought that shuns equities  in the name of avoiding risk? If yes, are we doing the right thing? So, Invest in Equities or Equity Mutual Funds.

What is Risk?

In simple terms, risk is uncertainty. Uncertainty that can affect us adversely. In our daily lives, risk of losing a job, risk of falling sick, risk of injury, risk of accident, are some of the risks that we think of. Similarly, the risk of losing our hard earned money also worries us. To a large extent, our earlier experiences influence our behaviour with respect to risk.

Is losing money the only financial risk?

There are a number of stories of people who bought stocks at high levels and sold them when the markets crashed, incurring huge losses. This bitter experience makes us averse to equity. However, is this the only financial risk that we need to worry about?

Inflation is a hidden risk

When Mr. A invested Rs.1,000 in a Fixed Deposit, Rs.100 could buy 4 apples (Rs.25 per apple). After 5 years, let us say, the maturity amount he gets is Rs.1,500. However, during the 5 years, the price of apples has doubled to Rs.50 per apple and he can now buy only 2 apples with Rs.100. Earlier, he could buy 40 apples with his Rs.1,000. Now, with Rs.1,500, he can buy only 30 apples. Is this not a loss? Should we not worry about the risk of rising prices? In fact, rising prices is more of a certainty and the only thing uncertain about it is the rate at which the prices will rise.

Many people understand this phenomenon. When I tell this simplistic example to participants, the normal reaction is “Yes, we understand inflation, but you are over exaggerating it in your example. Inflation is in single digits”. I agree. I am exaggerating it a bit for simplicity. However, single digit inflation is a myth. Check the prices of your consumption basket – fruits, vegetables, foodgrains, electricity bill, water bill, taxi rides, and if possible, compare them with what used to be your spend a year ago?  The inflation you experience is much higher than what the Consumer Price Index reveals! Inflation steals money from us without we realizing it.

Interest Rate Reduction

Various business leaders have been advocating reduced interest rates. There is a whole lot of Economics that needs to be understood to arrive at the right conclusion. We will address that in a separate blog. However, we do not have any association or body representing the depositors’ viewpoint. A large number of people, particularly senior citizens, depend on “fixed income” instruments such as Post Office savings schemes, Fixed deposits and Bonds. Would a reduction in interest rates not be a risk to such investors?

How to protect ourselves from the risk of inflation and falling interest rates?

Gold, Land and Equities offer a hedge (protection) against Inflation. In a separate blog, I had advocated having Gold as a part of our portfolio. Land, or Real Estate, is not a financial asset, unless we have mutual funds investing in Real Estate. REITs do not serve the small investor’s purpose. As a real asset, investment in Real Estate requires huge amount of money. It also scores low on Liquidity. Thus, that leaves us with Equity as an option to protect ourhttps://s3-ap-southeast-1.amazonaws.com/jamaappprod/wp/img/Equity+funds.jpg investments from the risks of inflation and falling interest rates. But, Equity is the MOST risky investment! Or is it, really?

What is the risk involved with Equity Investments?

It is true that equity investments are risky. However, we need to understand the risks associated with Equity. Investment in Equity is exactly like investing in a business.  Imagine yourself and a friend of yours starting a small grocery store or a service centre. We will think a hundred times about all the pros and cons before we put our hard earned money at stake. In other words, our investment will follow our conviction about the idea. Since we are convinced about the idea, we will give it our all and be in it for the long haul. In spite of all this, we could make tactical or strategic errors and the business may fail. Thus, the big risk with business is that it may fail.

When you buy 1 share of Reliance Industries Limited, you are effectively entering into a partnership with Mukesh Amabani ( and several others) to run an oil and Gas to Retail Vertically integrated business. On your behalf, Mukesh Ambani and some others have done enough homework about the business. They are there in it for the long haul and will give it their all. Yet, the business may fail.

Another risk associated with equity is that we may have bought a good business, but at a wrong price. In other words, we paid much more than the business is currently worth. Retail investors are often guilty of investing into equity at peak prices. The reason for the same is that we generally make our investments based on advice of an “expert”, who could be a knowledgeable friend, a broker, someone who knows someone who is an ace investor, and so on. While there is nothing wrong with such advise, we do not understand the basis of such recommendation. Also, our “expert friend” has no accountability for the advise and while he/ she would have sold the investment at an opportune time, there is no way he/ she can remember all the people to whom the advise to buy was passed on. We are left stranded with the stock while the rest of the world has already exited.

Lastly, the most disturbing reason for investing in equity is our desire to make quick profits. Equity investments are the best asset category for building wealth, but they are no “get rich quick” solutions. We buy a stock hoping that it would double or triple in a few days. When that is not happening, we run out of patience. One piece of bad news at such a time is enough trigger for us to sell the stock and book our loss!

The Silver Lining

It may sound cliched, and almost every body says this, but the good part of investing in equities is that they give you inflation beating returns (on a conservative basis) over the long term. The guy who is running the kirana tore may be making more money than the young software professional. That is because, the returns are much higher in business. In most cases, even if the investment is made at high valuations, but in good stocks, the investor earns a decent return over the long run.

Missing out on the most tax effective asset class?

Equities are the most effective instruments from the perspective of taxation. Dividends are exempt from tax. Dividend Distribution Tax is not applicable. There is no Capital gains tax if held for a period of 1 year. Even short-term Capital gain is subject to a flat rate of 15%. The rules are same irrespective of direct investment in equity or through mutual funds.

What does not work with Equities?

Hoping to make a quick buck on some hot news often results in investors like you and me incurring losses. Those who make money are probably plain lucky and should be buying lottery tickets for even more super-normal returns!

Taking a short term view is risky. If you have a financial commitment over the next 5 years, it is preferable to park the money in debt. Equity is strictly for long term investors. The technical definition of long term is more than 10 years, and not more than 1 year as our Income Tax rules suggest! If you are not in for the long haul, equity is not for you.

Investing in equity without understanding the business is like entering a blind alley. You do not know what is in store.

Who should invest in Equities?

Almost everybody can invest in equity. The only exception is a person who needs money in the short term. If your financial goal is falling due within the next 5 years, it is preferable to move your investments into debt.

 

 

How should I invest in Equity?

To tackle the various risks associated with equity, such as study of the business, valuation of such business, etc it is highly recommended that we take professional help. Instead of investing directly into equity, invest in direct mutual funds that are equity oriented. Just remember, whether it is direct equity or equity oriented funds, investment in equity should be for a time horizon in excess of 5 years. Of course, mutual funds allow you the flexibility to liquidate your investment any time, but realization of financial goals can happen only by allowing equity to work for you.

How much Should I invest in Equities and Equity mutual funds?

There cannot be a generalized asset allocation for one and all. A professional investment advisor such as a CFP or a RIA will help you arrive at the right allocation.

Conclusion:

Equity is an asset class that provides inflation beating returns. Do not ignore or avoid equity investments considering Equity as risky. Risk is involved in fixed income securities also. Choose equity as per a customized asset allocation. Invest in direct mutual funds that are equity oriented.

Happy Investing!

 

 

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