Mutual funds vs direct stocks: Why most investors overrate their stock-picking skills
With markets mostly going up one-way post pandemic, there has been a growing view that direct stock investing is the new normal for wealth creation. New investors, unbeknownst to the recency bias at play here, wonder: can’t I beat mutual funds by picking stocks on my own? Most think they can.
In spite of all its potential, I do not think investing directly in stocks is for everyone. Some will do very well in it, no doubt. But the majority are better off without it.
Looks simple, but isn’t easy
When you invest in direct stocks, the main aim is to beat markets (index). And by investing in stocks directly, you definitely have more control to build a focused, convictionallocated portfolio that attempts to beat markets (and normal mutual funds). But where there is potential for higher, market-beating returns, so is the risk of messing things up. So, if just a few of your stock picks in a concentrated portfolio do badly, then leave alone beating markets, your portfolio won’t even beat a docile savings account interest!
Another aspect that most people overlook is that picking a few good stocks occasionally is one thing. But generating market-beating returns from a portfolio of such stocks, that too consistently for years (like many good mutual funds have), is a different animal altogether. As they say in markets: being right and making money are two different things. Seasoned investors who have seen multiple cycles know this. In fact, if most equity investors compared their stock portfolio returns with proper benchmarks, they would be shocked to see that despite their efforts, passion, and self-confidence, a vast majority don’t beat the simple Nifty50!
Sustaining returns over the long haul demands effort, rigorous research, disciplined risk management, constant monitoring, and having a repeatable process that adapts well to shifting market dynamics—things that even professional fund managers struggle with, let alone retail investors juggling day jobs and limited expertise.
Equity funds
85-90%
(Low chance of big losses)
Direct stocks
10-15%
(High potential upside)
For most, MFs > direct stocks Good stock-picking, for lack of a better word, is counterintuitive. And most people aren’t wired to think in a manner that (behaviourally) helps them pick stocks well. To top it all, investors tend to overestimate their stockpicking abilities, more so when markets have done well in last few years.
For most, simple mutual funds are sufficient and should form the core equity allocation. A well-managed portfolio having a mix of active and passive funds provides sufficiently good investment outcomes with high probability and peace of mind. It’s not glamorous or entertaining, but it works.
And to be fair, there is no perfect strategy, and you can pick flaws in every strategy (like even investing in mutual funds) if you armtwist historical data. But a strategy is good if it probabilistically works well in most scenarios and, more importantly, is one you can live with over time without bailing out at stressful times. And investing in mutual funds for equity exposure is one such strategy. Boring, but effective.
That said, if you still have this primal urge to invest in direct stocks, then don’t let this deter you from exploring direct stocks. Many investors are able to incorporate both direct stocks and mutual funds into their portfolios. Here is how to go about it using a lopsided Barbell Strategy, (see graphic) inspired by statistician Nassim Nicholas Taleb’s strategy he used as a financial trader:
- Invest 85-90% of equity portfolio in mutual funds first.
- Just a few equity schemes from different categories that diversify sufficiently across different market caps, styles are enough.
- For the remaining equity exposure, start small and invest in direct stocks up to 10-15% of your portfolio.
- Do your own research/analysis to build conviction. Sincere advice — do not invest based on random social media tips.
- Do not be tempted to go more than 10-15% in the initial few years.
- In a few years’ time, compare the returns of the two. It will automatically be clear whether your direct stocks or MFs are doing better. And this assessment period should ideally include a stint in falling/sideways markets as well, because that is where real investment skills get tested.
- If your stock portfolio is still doing better after few years, you can consider increasing your allocation to direct stocks to more than earlier 10-15%. That is assuming you still enjoy the process of researching stocks and your confidence increases.
The author is founder, stableinvestor