This article was originally published in Postnoon on May 4th, 2012
I was waiting for Srikanth to come back to me. I knew that he was convinced about investing in stocks. He had the risk appetite and the ability to take the risk of investing in stocks. But, he did not know how to pick or select stocks. And that is what brings him to my room today.
Srikanth: Prof. Nicky, I have been reading the financial newspapers, listening to experts on TV, talking to my friends and family and going through stock price charts. I am not able to understand which stock I should put my money in. Moreover, you had once told me about not putting all my money in one basket. How do I select which sectors and which stocks to put my money in? Can’t you do it for me?
Prof. Nicky: No. I will not do it for you. I am an academician. Not a financial advisor. But there are people who can do it for you.
Srikanth: Really? Who? Are they expensive?
Prof. Nicky: Yes, I am not joking. You can invest your money in a Mutual Fund. Mutual Funds are managed by fund managers who have expertise in stock picking and analysing the companies based on their performance. In fact, in India, close to Rs6,00,000 crores is being managed by the mutual fund industry.
Srikanth: That is a mind boggling figure! How do they function? Are they expensive?
Prof. Nicky: The Mutual Funds take money from many investors and the fund manager invests the pooled amount in the stock markets (or the other markets like debt, money market, commodities). The cumulative returns from these investment, are passed on to the investors, after deducting the expenses of running the fund. Hence the expenses of running the fund and the salary of the fund manager is shared by many investors.
Srikanth: Seems like a lot of power is given to the fund manager. What if he is not good at his job?
Prof. Nicky: Hmmm…the fund managers are governed by strict guidelines on fund objectives, sector weights, risk and other stock selection criteria like liquidity, size and so on. Also, most of the funds hire qualified, experienced professionals as their portfolio managers. A little bit of personal bias is bound to be there and you should be prepared to take that risk. The information about the performance of a fund is easily available. There are fund managers who are more consistent in giving better returns. You can chose the fund on the basis of who manages it, apart from looking at the risks and returns.
Srikanth: How is the return on a Mutual Fund calculated? Since the fund invests in many stocks, how do we know the return on the fund?
Prof. Nicky: Good Question. I am glad you are thinking. In the case of mutual funds, instead of Prices, we have the Net Asset Values (NAVs). The NAV is the net asset of the fund (total assets minus liabilities) divided by the total number of outstanding units. Just like shares of a company, you have units of a mutual fund. The value of a unit is referred to as the NAV. You can calculate the return by taking the difference in NAVs on the date of investment and the date of selling the units divided by the NAV on the date of investment.
Srikanth: So it works just like shares?
Prof. Nicky: Exactly like it. And you get the benefits of an expert investing your money for you, you save time, you have a better diversified portfolio, and you may even invest in a tax saving scheme if you want.