Why stock-picking isn’t for every retail investor

Investing is fundamentally about utilizing your money wisely to generate greater wealth over time. Investors can choose between two primary approaches: selecting and managing individual stocks or entrusting the task to professional fund managers through mutual funds. While the latter eliminates management fees and maintains full control, it also overlooks the fact that professional management includes research, portfolio construction, risk management, execution, and behavioral discipline.

For most retail investors, attempting to replicate these tasks alongside a full-time job may not be the most efficient use of their time or money. Professional fund managers, however, provide a more efficient path to long-term wealth accumulation.

The internet, artificial intelligence (AI), and financial information have become more accessible than ever. Nevertheless, having access to information does not guarantee its advantageous application. Professional fund managers have teams of analysts monitoring various sectors, competitors, business cycles, regulation, accounting practices, and management quality.

They may even meet with company management, engage with suppliers and distributors, and visit manufacturing facilities to ensure the reported numbers match reality. The depth of this expertise is crucial, as a business may be performing well but a new competitor could fundamentally alter its economics. Identifying such shifts is challenging based solely on share price or a tip from someone else.

One major challenge is behavioral. Investors are naturally emotional about their money. A sharp decline in a stock's price can be difficult to view objectively. For instance, Bajaj Finance's stock fell from Rs.4,923 in February 2020 to Rs.1,783 in May 2020, a 64% decrease from its peak. Professional investors can capitalize on such opportunities by purchasing at lower prices, but non-professionals often lose due to panic.

Similarly, when a stock's price rises sharply, investors may be reluctant to sell, fearing missing out on further gains, even if the valuation becomes excessive. This often results in holding onto losing investments for too long and retaining winning investments for the wrong reasons. Professional fund management helps distance emotions from decisions by incorporating investment committees, research frameworks, portfolio limits, and regular reviews, thereby reducing the likelihood that one person's fear or excitement influences the portfolio.

Another critical factor is execution. Even if investors excel at research and manage their emotions well, they may lack the time to act on their decisions. Markets can produce opportunities or diminish values rapidly. A business can decline 30%, 40%, or even 50%. These falls can either become opportunities or permanent losses, depending on how one responds.

A professional investment team can act promptly on developments, turning declines into opportunities or preventing permanent losses. However, retail investors may be occupied with their professional or personal lives and unaware of the changes occurring in the market.

Even if executed correctly, tax can still negatively impact returns. The composition of a successful long-term portfolio cannot remain static forever, as businesses decline, new companies emerge, and competitive advantages disappear. Even indexes change their constituents over time. Thus, if an investor manages individual stocks, they must continually buy and sell stocks.

With each sale, there is an immediate tax cost. Mutual funds, however, have a structural advantage. The fund house benefits from an income-tax exemption under Section 10(23D) of the Income Tax Act, 1961. The fund manager can sell one stock and purchase another without the investor paying capital gains tax solely due to the portfolio change.

For investors in mutual funds, tax is only incurred when they withdraw their investment, allowing for tax-free portfolio changes within the fund every time the fund manager buys or sells a stock. Over the long term, the tax advantage alone outweighs the fund management fee.

Some investors possess the knowledge, temperament, time, and discipline to research businesses deeply and manage their portfolios successfully. For them, direct investing can make sense. However, these individuals represent an exception from a time when information asymmetry and no taxes existed. Today, direct investing is a difficult task. Investing is about building wealth, not proving one's ability to pick stocks. For the majority, professional management is a rational trade-off.