Let’s meet three different individuals who ask the same question- where do I invest in?
Sophia has planned for a long-term saving goals. She is planning to buy a home in the next five to seven years. She need to save for a down payment and wants to borrow as low as she could- everybody should work on the same concept. No one likes to pay double the amount you borrowed, which eventually turns 2X with the home loan interest rates in India over the years.
Sophia works at Multinational firm as an associate and after all the living and spending expenses, saves a small amount every month, which she is looking to invest for her home. She has a small amount of money to start with today, and plans to keep investing a more or less the same amount every month.
Secondly, Sophia doesn’t want to spend a lot of time searching for good stocks to invest in, and wants that set amount to be automatically deducted from her saving account every month- yes we are talking about Mutual Funds. The mutual funds allow Sophia to set up an automatic regular purchase plan- what we often call as SYSTEMATIC INVESTMENT PLANs (SIPs). 8 things to know about SIPs – A guide
Let’s talk simple- mutual funds are professionally managed investment programmes made up by a pool of investors who share a common goal. Now let’s understand it bit by bit-
Mutual funds are managed by professional fund managers. What do they do for you- they are responsible for allocating your money in different market instruments- equities, debts, real estate, everywhere. A fund manager diversifies your portfolio. Imagine yourself sitting every day and finding top performing stocks to invest in- you can surely do that if you are a finance expert, have experience in identifying stocks and have got nothing else to do. But what if you are a working professional like Sophia and don’t have time or knowledge to do so every single day. The fund managers would do that for you.
It is similar to investing in stock markets with a professional help- and the diversification is the key. Never hatch all your eggs in the same basket, they say. We all are aware how sensitive market is- one 140 characters Tweet from President Trump, and market crumbles like anything. What if your holdings come into that bracket? The fund managers allocate these funds into various categories to minimize the risk.
Pool of Investors
it is simple- it’s Sophia, and you, and all the other investors who have common goals like Sophia to buy a home after 5 years. With a small amount every month, you can buy small amounts of every stock, or debt, but with mutual funds, you can diversify your portfolio.
Sophia wants to buy a home after five to seven years. You might want your kids to study abroad after 15 years. I have some retirement goals- everyone’s need are different, and for each of these goals, there are hundreds of plans available in the market.
Now let’s talk about Tom, who is a trader and invests on a fairly regular basis. Tom has been into stocks and commodity trading from a long time and understands the market functioning and fluctuations. Tom largely trades Intra-day calls and wants the flexibility of placing orders any time during the active trading hours.
Tom also understands the importance of using a lot of strategies to diversify his portfolio to minimize risk. Every morning Tom places some subscribed tools or scanners that give some sort of projections of stocks for the day for Tom to position his calls.
Now, if Tom wants to invest in a single point to invest in during intra-day trading, ETFs (Exchange-Traded Funds) can have an edge over mutual funds for Tom.
ETFs provide a lot of flexibility as compared to mutual funds as they directly trade on exchanges, as the stocks do. Hence, this allows Tom for Intra-day trading and comes up with a lot of trading strategies Tom is looking for. These include Option trading, buying and selling on margin and limit orders.
Mutual funds are only priced once per day, and can be only be traded on previous day’s closing price, or NAV (Net Asset Value). Where it minimizes risks for the long term investors like Sophia, it is not favourable for Intra-day traders like Tom. Here, ETFs have an edge over mutual funds for frequent traders.
Finally, at the end of the day, Tom would like to know what he owns and why. With ETFs, Tom can easily review his portfolio holdings and also, monitor his portfolio risk exposures. In ETFs, holdings are disclosed daily, unlike most mutual funds. This provides greater visibility to the investors like Tom.
Now let’s see what Eva, a highly paid working at a senior level, can do to minimize her taxes. Eva finds herself in a high tax bracket, and is quick concerned with the taxes. She is looking for tax saving plans to work on her taxes. After going through a lot of mutual funds and ETF plans, she finally inclines more towards ETFs.
In general, between a similar mutual fund and ETF, an ETF is more tax efficient as compared to mutual funds. We will see how-
Let’s say Eva owns some shares in an ETF plan, and another share holder in the same plan decides to sell some of her shares. That other shareholder would simply sell her part of stocks to other buyer- just like selling stocks in stock markets. In this case, there would generally be NO CAPITAL GAINS transactions for the ETF plan as a whole, or for the shareholders of the plan. This would avoid Eva’s earnings exposure.
However, if in a mutual fund plan, if a seller is willing to sell some of his shares, the mutual fund may need to sell some securities to raise the cash/capital needed to make that redemption, which might incur capital gains for all the other shareholders. As Eva doesn’t want exposures because of the actions of other shareholders, she would prefer to go with an ETF plan.
We covered three different people with three different needs in this write-up. We often come across lucrative investment plans that end up saying market investments are subjected to market risks- very true. But, if we know our goals and plan accordingly like Sophia or Eva, we would end up getting some good returns, and saving a lot in taxes.
What are your thoughts? Where do you want to invest?