Why first-time investors could consider mutual funds instead of stocks

For new investors, the stock market can seem like a maze, with so many shares to choose from and so many risks to consider. In such cases, mutual funds can be a suitable alternative to direct stock investments.

By combining many investors’ money into a diversified portfolio, mutual funds offer a simpler, more affordable and potentially lower risk way to invest in the stock market while benefiting from professional management.

This guide will explain how mutual funds benefit new investors, comparing direct equities to mutual fund structures and tips on how to get started. By the end, you’ll know how mutual funds for beginners can be used easily to enter the market and generate wealth over time.

• Table of contents

• What can make mutual funds appealing to beginners?
• Key fundamentals: Understanding mutual funds for new investors
• Risk comparisons: Mutual funds vs. individual stocks
• The merits of professional management in mutual funds
• Costs to consider
• What steps should a beginner take to start investing in mutual funds?
• Tips for successful investing

What can make mutual funds appealing to beginners?

• Diversification: Each mutual fund comprises multiple stocks, rather than just one or two, which can reduce risk by spreading it across different investments.
• Affordability: Most funds have a low minimum investment requirement, allowing investors to start with smaller amounts.
• Professional management in mutual funds: Skilled fund managers take care of security selection, helping newer investors access nuanced strategies and trading techniques.
• Regulatory safeguards: Mutual funds operate under strict guidelines that seek to safeguard investor rights and foster transparency.

For these reasons, mutual funds can be a viable alternative to stock for beginners navigating a complex market.

Also Read: A beginner's guide to index funds

Key fundamentals: Understanding mutual funds for new investors

What are mutual funds? They are investment vehicles that gather money from multiple investors to buy various assets—such as equities, bonds, or both—following a stated objective. The fund’s net asset value (NAV) changes daily as it is directly influenced by market movements of the underlying portfolio. Each unit of a mutual fund effectively represents fractional ownership of all the assets inside it. Here are some key terms and concepts.

• Units or shares: You do not own direct individual stocks, instead, you hold fund units representing a portion of the combined holdings.
• Fund categories: Equity funds invest chiefly in stocks, debt funds on bonds and hybrid funds combine both.
• Active vs. passive management: An active fund is one where the fund manager will research and pick stocks using his expertise, while passive or index funds track a benchmark like the Nifty 50 or BSE 500.

Risk comparisons: Mutual funds vs. individual stocks

Looking at stock for beginner investing, you’ll understand that even though investing in direct stocks of companies might potentially lead to more returns if that company does well, it involves higher risk. A poorly performing stock can heavily damage a small portfolio. Why are mutual funds good for beginner stock investors? Because:

• Diversification: Even if one stock within a fund drops in value, others may balance or offset those losses.
• Professional management: A professional manager looks at market trends, economic indicators, and each security’s fundamentals to make such a selection – something that a new investor may not have the required expertise to do.
• Lower volatility: While still exposed to market risks, mutual funds may display less volatility than concentrated positions in a single or handful of stocks.

The merits of professional management in mutual funds

Professional management in mutual funds is a prime selling point for novices and offers the following benefits:

• In-depth research: Fund managers and their teams analyse countless data points—company financials, competitive landscapes, macroeconomic variables—to create a balanced portfolio.
• Active monitoring: They keep an eye on performance and rebalance whenever needed.
• Potential outperformance: Actively managed funds led by skilled managers have the potential to outperform the broader market in the long term while mitigating risk by skillfully managing market phases.

Costs to consider

Mutual funds charge investors for professional management, operational services and administrative expenses. Here are some expense heads investors should know.

• Expense ratio: A percentage that is charged annually for the fund's management. Lower expense ratios usually mean a larger portion of your potential gains staying with you.
• Exit loads: Some funds charge a nominal amount for premature redemption.

What steps should a beginner take to start investing in mutual funds?

• Determine goals: Are you saving for retirement, buying a home, or building an emergency reserve? Goals inform fund selection.
• Pick a fund category: Debt funds can be suitable for relatively conservative investors. Equity funds can be considered by investors with a high risk appetite who are seeking long-term growth potential. Hybrid funds can provide a middle ground.
• Set up an account: You can invest through a mutual fund distributor, online aggregator platform or directly through the fund house. Complete the necessary KYC (Know Your Customer) procedures.
• Invest: Invest a lumpsum or opt for an SIP (Systematic Investment Plan) if you prefer smaller monthly contributions.
• Check periodically: Though it is important not to panic on short-term dips, reviewing your portfolio every six months can help you assess if you are still on track with your goals.

Tips for successful investing

Here are some things investors avoid when investing.

• Chasing past returns: A top-performing fund last year might not deliver the same performance this year. So, instead of chasing returns, look for funds that have performed relatively consistently over time. Checking returns over multiple horizons and looking at risk-adjusted return metrics such as beta, Sharpe ratio and information ratio can help. *Past performance may or may not be sustained in future.
• Ignoring risk tolerance: Do not invest all your money into a high risk segment fund unless you can handle big swings.
• Frequent switching: Exit loads or fees on switching funds eat into the capital and you might lose the effect of compounding.
• Skipping research: Understanding the scheme objectives, investment style and portfolio composition is essential even though the investment will be handled by a professional fund manager.
• Failing to diversify: Holding only one fund or too many funds in the same style does not lead to optimal diversification.

Also Read: Why should youth start investing in mutual funds?

Conclusion

For novices entering the stock markets, understanding why mutual funds are good for beginner stock investors can aid decision-making. Mutual funds help manage risk through diversification and professional management. There are various mutual fund options, making them suitable for several goals and risk tolerance levels. That said, do not forget to check the fees involved and ensure the scheme aligns with your risk appetite. Avoid emotional, short-term reactions.

FAQs:

What exactly are mutual funds, and how do they work for beginners?

Mutual funds combine money from various investors to buy stocks, bonds, or other assets, managed by professionals. Beginners benefit from diversification, not much stock picking to worry about, and potentially stable growth.

Why are mutual funds considered a less risky alternative to individual stock investments?

Holding one or two stocks exposes you to high risk if those picks decline. Mutual funds invest across multiple securities, averaging out the impact of any single underperformer. Moreover, stock selection requires considerable knowledge and expertise, which beginners may not have.

How do mutual funds help in diversifying an investment portfolio?

They spread your funds across diverse companies, sectors, or even asset classes. This distribution reduces risk because underperformance in one sector/stock or asset class may be balanced by the other securities in the portfolio.

What should new investors know about the fees and expenses associated with mutual funds?

Be aware of expense ratio, any or exit loads, and other fees. Lower fees mean a higher percentage of the potential returns stay with you.

What steps should a beginner take to start investing in mutual funds?

Have a clear understanding of your goals and risk tolerance, choose a suitable category (e.g., equity, debt, or balanced), set up an investment account, and choose between lumpsum or SIP. Monitor progress periodically.