What is the fuss?
At some point in your career, you will rely on investing to generate wealth and plan for retirement. Typically, the majority of us start with mutual funds, which are a safe and easy way to start investing.
And all of us, at some point, try our hand at stock picking, which means direct investing in the stock market.
Many of us who try stock picking burn our hands. We lose money or book profits too early to make a satisfactory return.
Investors often compare returns from stock picking with mutual funds. We see that returns from mutual funds are better. Then, we refrain from stock investing or keep stock picking as a hobby, allocating a small percentage of our total investment.
What if I told you that, if done right, individual stock investing can give higher returns than mutual funds in the long term?
The important part here is “done right” and “long term”.
You need experience, basic financial knowledge, and emotional control. Combine these three ingredients, and you get the recipe of a seasoned investor who knows his stock market plays.
Long-term is important as the stock market rewards patience, letting compounding work its wonder.
So, if you can pick stocks well and sit through their compounding cycle, you will generate more returns than what a typical mutual fund will give you.
In this post, I give seven reasons why returns from individual stock investing can beat those from mutual funds. Let’s get started.
Reason 1: Control to Buy at a discounted price
Money is made in the stock market by buying low and selling high.
To make this money-making process work, you need to buy at a low price. This means buying a stock at a fair or discounted valuation and then waiting for it to appreciate over time.
However, when you invest in a mutual fund via SIP or as a lump sum investment, the mutual fund manager must invest your money the same day.
This means the mutual fund will buy the stocks in its portfolio at any valuation on the day you invest. If it is at a high valuation, it will buy stocks at an expensive valuation, limiting your upside returns.
When you buy stocks individually, you are not constrained similarly. You can wait a day, a week, or a month to buy stock at the right price.
Stock buying features such as Limit Orders and Good-till-Triggered (GTT) orders help with this. I love GTT orders, where I can set a buy price for a stock. The GTT order is only triggered if my buy price is hit.
And the cherry on top is that GTT orders expire after 365 days or one complete year. This means that once I have decided on a discounted buy price for a stock, I can place several GTT orders that will help me buy in a staggered manner for the entire next year. Talk about lazy investing at its best.
Reason 2: Control to Sell stocks at an insanely high valuation
A corollary of reason 1 is the control you get at selling stocks at the right price when the market is overvalued and the stock is valued insanely high.
Why would you sell a stock? During phases of euphoria, stock prices start trading at unreasonable valuations. If you have a stock you want to exit from, this is a great time to do so.
I also use these euphoric opportunities to trim down my stock portfolio and exit from some tracking stocks in which I no longer plan to build a sizeable position.
Reason 3: Control to buy/sell single stocks and not the entire portfolio
All industries are cyclical. This means that their revenues and stock prices go up during an upcycle. And their revenues stagnate during a downcycle, as do their stock prices.
Different industries go through different cycles of varying durations. At a given time, one industry can be in an upcycle and another in a downcycle.
Returning to the money-making process, which states buying low and selling high.
Now, to make money, you can buy stocks at low valuations during a downcycle, hold your investments during an upcycle, or trim some peaking stocks a little to rebalance.
As an individual stock picker, you can selectively buy some stocks in your portfolio, hold on to some, and sell some from your portfolio. But you don’t get this control as a mutual fund investor.
A typical mutual fund portfolio, let’s say a small-cap portfolio, would have stocks from every industry: Finance, Infrastructure, Pharma, IT, FMCG, Energy, Automobiles, etc.
When you invest in a mutual fund, the fund must buy all stocks in its portfolio simultaneously. You do not have a stock-level control but a portfolio-level buy option.
This constraint limits the buying at a low valuation part, step 1 of the money-making process.
In my stock investing experience, I have seen stocks in a given industry dip, and my GTT orders for those stocks have been hit.
Sometimes, banking stocks are down (early 2024), sometimes, alcohol stocks are down (late 2023), and sometimes, chemical stocks are going through a downturn (early 2023).
Hence, I buy different stocks in my portfolio at different times of the year, as the valuation froth keeps shifting from one industry to another. This makes the overall valuation at which I buy low, lower than what a typical mutual fund would have.
Reason 4: Ability to get in and out of stock quickly
When a large fund house buys a stock, it cannot buy all the required shares at a single price. This price keeps increasing as it buys more. Let me explain.
When a bulk order is executed, the initial buy price at which execution starts might be lower than the final price when the execution ends.
When a large order is placed, it takes time to execute, as enough sellers should be willing to sell that stock. During this matching of willing sellers and bulk buyers, the stock price can increase.
Why appreciate? The market reacts to the increasing demand for stock, thus increasing its price. The new buy orders for the same bulk order might get fulfilled at a slightly higher price.
Now, retail investors like us don’t face this constraint. A bulk order is an order that buys more than 0.5% of a stock or is larger than INR 10 Crore in value. Most retail investors fall far below this definition of a bulk order.
This actually gives retail investors an edge to move in and out quickly. As the value of our orders is small, we can accurately get the buy price we want and the sell price we demand. Neat, isn’t it?
Reason 5: No Constraints on allocation to one stock, one industry, or one category
Mutual funds are regulated. Their main objective is to protect investors’ money and then provide a healthy return on that money.
Many mutual fund managers refer to themselves as managing risk rather than managing returns, and rightly so. The regulations laid down by SEBI, the regulatory body for mutual funds, put certain constraints on mutual fund houses to ensure this.
A mutual fund cannot invest more than 10% of its portfolio in a single company (refer to the discussion here).
A large-cap mutual fund must have at least 80% of its portfolio invested in large-cap companies.
A mid-cap mutual fund must have at least 65% of its portfolio invested in mid-cap companies.
A small-cap mutual fund must have at least 65% of its portfolio invested in small-cap companies.
And so on and on. You get the idea.
Regulations restrict how a mutual fund can construct and maintain its portfolio. However, you are not bound by such restrictions as a retail investor.
Let’s say you are tracking the government’s defence expenditures for the next five years. To reap the benefits, you might invest 30% of your portfolio in two or three defence sector companies.
Or, a new contract of smart meter devices is around the corner, and you invest heavily into a listed stock most likely to win the bid in this segment.
Your portfolio may be heavily concentrated in small caps in 2024 and large caps by 2025.
When not bound by constraints, you can invest freely without worrying if you buy more into a stock, industry, or stock category. You simply invest to maximise your returns.
Reason 6: Benefit from a Concentrated yet Diversified Portfolio
As we read in reason 5, mutual funds’ priority is managing risk and protecting the invested capital. A good way to do this is to diversify. A little over-diversification helps reduce the risk further.
How does it reduce risk? Well, if you have 100 stocks in your portfolio, and one stock goes bust, it will impact only 1% of your portfolio. Which is negligible.
On the other hand, if you only have one stock in your portfolio, and it goes bust, you will lose 100% of your invested capital. Not good, right?
But here is a catch. How much should you diversify? Well, this number varies. However, most veteran investors, such as Warren Buffet and Mohnish Pabrai, advise a 10–20 stock portfolio as ideal for diversification.
Mutual funds lie at another extreme of diversification. Typically, they have more than 50 stocks in their portfolio. And many times, it is more than 100 stocks.
What’s wrong with over-diversification? Well, it limits your overall returns.
Let’s take the same example as above. Your portfolio has 100 stocks. One stock doubles in value. However, your overall portfolio will only increase by 1% as you are over-diversified.
But if you had 20 stocks in your portfolio and one stock doubled in value, your overall portfolio would increase by 5%. Nice!
As a retail investor, you can carefully pick stock to keep a concentrated yet diversified portfolio of 15–20 stocks. This way, when your invested stock gives large returns, your entire portfolio will increase significantly.
Reason 7: Ability to take risky bets for higher returns
Let’s say a narrative is being formed on an upcoming theme that will play out over the next five years. It can be an energy theme, as power demand is increasing. Or Electric Vehicle theme, as the world is moving towards cleaner energy sources.
You identify a few stocks, some untested ones, and decide to invest. As a retail investor, you can invest immediately, at the click of a button, in a couple of seconds.
Some risks can be involved if the theme doesn’t play out or the untested stock is a dud. But you don’t have to answer to anyone else but yourself. You are okay to take risks and move quickly.
Now, on the optimistic side. Given your good stock research and valuation framework, you would have chosen a decent stock that can ride the wave of the emerging theme well. You will make high returns as you enter early and ride the entire wave. Well done!
But what about mutual funds? For them, it is not that quick and easy.
Mutual funds are answerable to investors and regulators. They must explain if they exit a stock or if their portfolio underperforms the index they track.
They have to defend their reasoning and accept their mistakes. Sometimes, the underperforming fund manager might also be replaced. Ouch!
Therefore, mutual funds take their time to do proper due diligence. They ensure that their reasons for investing in a stock are justified and backed by properly documented research.
Usually, it undergoes two to three levels of reviews and discussions before a decision is made. It takes time and is not a day’s event.
So, even though a mutual fund might eventually enter the same stock you picked, the mutual fund will only get to ride the emerging theme wave for the last couple of legs. As you enter early, you ride the entire wave and make higher returns than a conservative due-diligence-ridden mutual fund would have made.
There you go. I hope that armed with these seven reasons; you feel recharged to get back to investing 101 and pick stocks to make your own concentrated yet diversified high-return portfolio.
Parting Thoughts
Investing in mutual funds is safe and reliable. But if you want to try getting higher returns by direct stock investing, you should know that it is possible.
It requires time. Your mutual fund returns might outdo your stock investing returns for initial years. But keep at it, picking the right stocks at the right price to build a small, high-quality, high-growth portfolio. Patience and inactivity get rewarded in the stock market.
And don’t forget the dividends you get directly into your bank account from stock investing. These dividends are added back to your mutual fund returns, thus making them a tad higher.
Have you tried both mutual funds and stock investing? What, according to you, is the edge one gets when individually picking stocks? Do share in the comments below.
Happy Investing!
Disclaimer: This post is not financial advice. Please do your research before investing.
