How is Investing in Mutual Funds Different From Trading Stocks?

Investing in mutual funds and trading stocks have become the most sought after options among millennials these days. As stocks and mutual funds are the only investments that have the potential to help investors meet their requirements sooner, they are naturally getting more investors. However, trading and investing are not the same. 

Trading has to do with buying and selling securities more frequently with the sole view of making short-term profits. Trading is suitable for those who are willing to assume higher risk levels in exchange for the potential to earn higher returns. On the other hand, you invest in making your dreams come true. Here are the major differences between investing in mutual funds and trading stocks:

1) Managing your investment

Finance professionals manage mutual funds called the fund managers. These individuals have an excellent track record of managing investments. They invest in the best-performing securities that have the potential to provide good returns in the long run. They are backed by a team of market analysts and researchers who continually look for the best options depending on the market scenario. Since you have an expert managing your investment, you only have to invest. 

On the other hand, if you are to trade stocks, you have to pick shares on your own. You will have to continuously keep tracking the market and economic developments before making informed decisions. This may not be possible when you are held up with something significant. You may miss out on an opportunity due to this. Therefore, if you don’t have time or knowledge to trade stocks, then you may consider investing in mutual funds. 

2) Risk factor

Trading involves higher risk levels as you tend to buy and sell shares every and now then. You make profits when the economy and markets are doing well, while you suffer a loss when you make wrong decisions. Also, since you only invest in shares while trading, the market and volatility risks are on the higher side. The short-term investment horizon is only going to make things worse as you are not allowing more time for your investments to recover from the possible losses. 

This is not the case with investing in mutual funds. The portfolio of a mutual fund carries lower risk as compared to trading shares. This is because a mutual fund invests across several securities. This is an advantage as the other securities in the portfolio can make up for the underperformance of one particular security. Therefore, if you are not willing to take higher levels of risk, then you may consider investing in mutual funds.

3) Cost involved

As you frequently buy and sell shares, the cost is higher. Every time you buy a listed equity share, you pay Securities Transaction Tax (STT). Apart from that, you have to pay for your Demat account, annual maintenance charges, brokerage charges, transaction charges, and stamp duty charges. The more you trade, the more cost you incur. 

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On the other hand, by investing in mutual funds, you reduce the overall cost of investment. This is because the transaction cost is spread across all the investors of a particular fund plan and is negligible compared to trading stocks. You will have to expense ratio, stamp duty (in case of equity funds), exit load and transaction charges. Not to forget, having Demat account is not necessary to invest in mutual funds. 

4) Diversification

To diversify your portfolio with trading shares, you need to buy and hold shares of several companies across sectors and capitalisation. This makes it difficult to track the performance of all the shares in your portfolio. Also, the cost of trading increases. Therefore, it is challenging to diversify your portfolio by trading shares. 

On the other hand, every mutual fund portfolio is diversified. A mutual fund scheme invests across various securities. You automatically get the benefit of portfolio diversification by investing in a mutual fund. Furthermore, mutual funds come in three main categories, and you can choose to invest in that scheme whose portfolio is constructed as per your needs. In simple words, a mutual fund is a readily available investment to diversify your portfolio. 

5) Taxability

All listed equity shares are taxed on the same lines. Dividends offered by shares are added to your overall income and taxed at your income tax slab rate. The rate of taxation of capital gains depends on the holding period. You make short-term capital gains on selling your shares within a holding period of one year. These gains are taxed at 15%. You realise long-term capital gains on selling your shares after a holding period of one year. These gains of up to Rs 1 lakh a year are tax-exempt, and any gains exceeding this limit are taxed at 10%. 

On the other hand, the taxation of capital gains offered by mutual funds varies across debt and equity funds while the dividends are taxed classically. The short-term capital gains (holding period of shorter than one year) of an equity-oriented fund are taxed at 15% while the long-term capital gains (holding period of longer than one year) of up to Rs 1 lakh a year are tax-exempt. Any gains exceeding this limit attract tax at 10%, and there is no benefit of indexation provided. 

You make short-term capital gains when you sell units of a debt-oriented fund within a holding period of three years. These gains are added to your overall income and taxed at your income tax slab rate. Long-term capital gains are taxed when you redeem your debt funds units after a holding period of three years. These gains are taxed at 20% after indexation. 

6) Disciplined investing 

Since you trade shares as and when needed for the sake of making short-term profits, it doesn’t help in instilling a sense of financial discipline. On the other hand, if you invest in mutual funds through a systematic investment plan (SIP), you get the habit of investing a sum at regular intervals. This, in the long run, helps you stay financially disciplined. 

Investing in mutual funds is recommended for those to achieve. Having a long-term investment horizon is beneficial as it helps you mitigate the associated risks to a greater extent. You may consider trading shares if you are willing to tolerate higher risk levels. 

For any clarifications/feedback on the topic, please contact the writer at vineeth.nc@cleartax.in