Mutual Funds vs Stocks: Weighing Risk, Returns, and Diversification

However, this is not the only factor to consider when making your decision. Stock prices fluctuate based on market movements, economic conditions, and company performance, and investors bear the full impact of this volatility.

Many individuals have suffered losses by acting on market tips or unsolicited advice without proper research.

In contrast, mutual funds pool money from multiple investors and invest in a diversified portfolio of assets such as stocks, bonds, or other securities.

A professional fund manager makes investment decisions on behalf of you, the investor, reducing the risks associated with investing in individual stocks while still providing exposure to the market's growth potential.

With this background, let us look at the different ways mutual funds have an edge over stocks...

1. Research-backed Diversification

When investing in stocks, your portfolio is typically limited to a few selected companies.

In contrast, mutual funds provide exposure to a broad range of carefully selected companies, usually 50-70 stocks. Since an equity mutual fund portfolio consists of multiple stocks, a decline in the price of one or more shares can be balanced out by gains in others. The distribution of risk across various securities (such as debt and money market instruments alongside equities) reduces the likelihood of a complete portfolio downturn.

[Read: Best Mutual Funds to Invest Now]

Now, you might assume that diversification could work just as well for stocks.

However, holding too few stocks increases risk, as underperformance by a handful of companies can significantly dampen your returns. Conversely, owning too many stocks without proper due diligence - say, 75 or more - dilutes potential gains, making it harder to generate meaningful returns.

The legendary investor Warren Buffett famously stated, "Diversification is protection against ignorance."

But there's a fine line between diversification and 'diworsification', where spreading investments too thinly reduces portfolio efficiency and potential returns.

Instead of chasing stocks that could be highly volatile and lose value when the momentum shifts, it would be sensible to go for an optimally diversified mutual fund portfolio.

Let's take the example of Ravi, a 40-year-old investor with a moderate risk appetite and Rs 10 lakh to invest. If he chooses to invest in individual stocks, he might buy shares of 10 - 15 companies, spreading his investment across sectors he believes have potential.

If five stocks underperform or face downturns due to market volatility, their losses could outweigh the gains from the remaining stocks. A few poor stock selections could significantly drag down his overall returns.

On the other hand, if Ravi invests in a mix of mutual funds - say, 60% in Large Cap Funds, 30% in Mid Cap Funds, and 10% in Small Cap Funds - his portfolio benefits from professional fund management and strategic asset allocation.

If certain sectors or market segments perform poorly, others may compensate, helping him maintain a relatively stable growth trajectory. The fund manager's expertise ensures that the portfolio is actively rebalanced, reducing risk and optimising returns.

2. Low Cost

The price of a single stock can range from a few hundred to several thousand rupees. To build a well-balanced stock portfolio, you would need to buy shares of multiple companies, often requiring an investment of several lakh rupees.

With mutual funds, however, you could hold units of multiple companies with a significantly lower investment amount.

Systematic Investment Plans (SIPs) allow you to invest as little as Rs 500 per month. Recently, SEBI has also proposed small-ticket SIPs starting from Rs 250, making mutual fund investments even more accessible.

3. Goal-Based Investing

Mutual funds allow you to structure your investments around specific financial goals, such as purchasing a home, funding a child's education, or planning for retirement. You can customise your mutual fund portfolio to suit your investment objectives, risk tolerance, and the time horizon to fulfil the financial goal. This can be achieved by selecting suitable types of funds such as equity, debt, hybrid, solution-oriented, and other schemes such as exchange-traded funds (ETFs).

For instance, equity mutual funds, which seek long-term capital appreciation but could be volatile in the short term, are suitable for investors with a higher risk appetite and a longer investment horizon. Conversely, a risk-averse investor may prefer debt funds, which have the potential for income generation and capital preservation.

You can further refine your choices within each asset class by selecting suitable sub-categories such as Large Cap Funds, Mid Cap Funds, or Multi Asset Allocation Funds.

Unlike direct stock investments, where buying and selling decisions are often ruled by market sentiment, mutual funds encourage long-term planning with a well-defined investment strategy.

Through SIPs and other systematic investment options, you can steadily work towards accumulating wealth while benefiting from the power of compounding over time.

[Read: How to Set Achievable Financial Goals And Plan to Achieve Them]

4. Professional Fund Management

Mutual funds are managed by experienced fund managers who possess in-depth knowledge of the capital markets. The fund manager/s carefully selects stocks for the portfolio based on in-depth research, considering various micro and macroeconomic factors. This ensures that you, the investor, have the opportunity to earn a reasonable return that aligns with the scheme's stated investment objective. Your role as an investor is to choose the mutual fund schemes that best aligns with your investment objective, risk tolerance, and investment horizon.

Investing in stocks, however, requires you to conduct thorough research on your own. You may not always have the time or expertise to identify the best stocks to invest your hard-earned money in.

Additionally, an annual review of your mutual fund portfolio is usually sufficient to track performance. Stock investing will require you to track your holdings much more frequently, making it a time-consuming and, at times, stressful experience.

5. Systematic Investments and Withdrawals

With mutual funds, you can invest and withdraw systematically through structured plans such as SIPs, Systematic Transfer Plans (STPs), and Systematic Withdrawal Plans (SWPs).

SIPs allow you to invest a fixed amount at regular intervals (monthly, quarterly, etc.), helping you average out market volatility and benefit from rupee-cost averaging. This approach ensures that you don't need to time the market, a challenge many stock investors struggle with.

Similarly, you can use an STP to shift money gradually from one mutual fund scheme (usually a debt fund) to another (typically an equity fund). This is particularly useful when transitioning from a low-risk investment to a higher-risk one, or vice versa, in a phased manner, something that cannot be done seamlessly with stocks.

With an SWP, you have the option to withdraw a fixed amount periodically, offering a steady income stream - ideal for retirees or those seeking liquidity.

In contrast, selling stocks for periodic cash flow could come with the challenges of timing the market and incurring additional brokerage charges.

To Conclude...

If you find yourself short on time, knowledge, or expertise to construct and manage a high-quality stock portfolio, investing in mutual funds is a prudent choice. With professional fund management, diversification, and structured financial planning, mutual funds help mitigate risks while ensuring exposure to market growth to achieve long-term financial objectives.

Selecting the right mutual fund requires a careful analysis of both quantitative and qualitative factors including past performance, risk-reward ratios, and the respective fund house's processes and systems.

If you need guidance, consider consulting a SEBI-registered investment advisor to identify mutual funds that best suit your financial objectives and risk appetite.

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DIVYA GROVER is the co-editor for FundSelect, the flagship research service of PersonalFN. She is also the co-editor of DebtSelect. Divya is an avid reader which helps her in analysing industry trends and producing insightful articles for PersonalFN’s popular newsletter – Daily Wealth letter, read by over 1.5 lakh subscribers.
Divya joined PersonalFN in 2019 and has since then used stringent quantitative and qualitative parameters to analyse funds to provide honest and unbiased research to investors. She endeavours to enable investors to make an informed investment decision and thereby safeguard their wealth.

Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.
This article is for information purposes only and is not meant to influence your investment decisions. It should not be treated as a mutual fund recommendation or advice to make an investment decision in the above-mentioned schemes.