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The middlemen of stock investing: mutual funds

“Eliminating the middleman is not as simple as it sounds. Fifty percent of the human race is middlemen and they don’t take kindly to being eliminated.” – Firefly

Investing basically means either lending to a business or taking a stake in it. These two approaches involve different risks and returns. So, how do we first find such investing opportunities, and then assess the accompanying risk and return?

Let’s use a simple example in which a friend asks you to invest in her restaurant. Say you decided to take a stake for the long term. Your friend runs the restaurant while you are a silent partner in the business – she is the ‘management’ and you are a ‘shareholder.’

Even though you intended to invest for the long term, a couple of years down the line, you need the money for something else. You can’t just demand your money back – it wasn’t a loan. Your friend has put the profits back into the business by expanding into new locations, etc.

Markets give you an idea of how much your stake is worth

So how do you get your money back? You can decide to sell your stake to somebody else.

The potential buyer will have the same questions about business prospects as you had. Since it’s been open for a while now, the teething issues are sorted and cash flow is stable. But there’s a competitor who’s opened up next door. So the buyer still has to figure out the restaurant’s future potential, and offer you a price accordingly.

Somebody else might come to you and offer a higher price. He knows the chef and believes the restaurant will do well despite the new competitor. Yet another person may come to you and make an even higher offer because he wants to merge the restaurant with his chain. He thinks he’ll be able to lower costs by combining overheads.As you can see, people will offer you different prices based on their outlook for the restaurant industry and that particular restaurant.

The various people making different offers on your stake in a business are collectively known as the ‘market.’ It’s no different from the market for anything else – think of the vegetable or fish market. A grower may stand with his produce and different people will offer different prices to buy his produce.

To make the process of bidding easier, somebody might put up a notice board on which the grower could list his asking price. Potential buyers might put up their offer price. The grower or seller might then accept the highest offer. The stock exchange is essentially this type of notice board. It reflects the various bids and offers on all companies’ equity components, and the people bidding make up the market.

So the stock market reflects all the bids for all the companies listed on the stock exchange. The last price at which the stock traded is considered the market price, i.e. the price at which a willing buyer and willing seller were willing to transact.

When the market prices of most stocks go up, the ‘market’ is said to be going up. Similarly, when the market prices of most stocks decline, the market is said to be going down. To capture these movements, there’s an ‘index’ – a hypothetical basket of one share from each company. So when the market price of these shares goes up or down, the index reflects that.

The most famous market indices that appear on TV tickers are the Dow (the top 30 stocks on the New York Stock Exchange) and the FTSE (pronounced ‘Footsie,’ representing stocks on the London Stock Exchange). In India, the Sensex is a basket of the top 30 stocks on the Bombay Stock Exchange, while the Nifty 50 represents the largest 50 stocks on the National Stock Exchange.

To recap, regardless of your valuation of the business, and therefore your stake, there will be other people in the market who might have a different opinion. These people could have different information or insights into the business, or use different valuation methods. Hence, they make different offers for the equity in a business on the stock exchange. These bids make the market go up or down on a daily basis.

It’s important to note that the market is only there to tell you what you could get if you want to sell your stake. You don’t actually have to sell at that price. You could wait until the prices are higher (unless of course you were wrong to have paid that much to start with, but we’ll discuss that later).

Mutual funds invest in stocks on your behalf

To invest well, you need to ask the business a whole lot of questions. You should also conduct some independent research by speaking to its suppliers, customers and competitors. You may also have to form a view on the economic and regulatory environment. This sort of analysis is called fundamental analysis. You then have to figure out how much to buy the stake for, and later assess all the bids being offered for your stake, called valuation analysis. Some people find this exercise fascinating, while for others it’s just a lot of numbers.

If you don’t have the time or inclination to do all this work, you could hire professionals to do it through a mutual fund. Mutual funds pool your investment with those of other people with similar objectives, and are overseen by a professional fund manager.

How do mutual funds decide who has similar objectives? They come up with a classification system. Debt is divided into two broad groups – debt or loans for less than 12 months are called ‘cash.’ Longer-term loans are called ‘bonds’ or fixed interest. If you lend to the government, it’s a ‘gilt,’ while if you lend to private businesses, it’s corporate bonds. Corporate bonds are ranked based on risk.

Similarly, equity can be ‘large cap,’ i.e. large companies, or ‘small or mid cap’ if they are smaller companies.All these classifications are called ‘asset classes.’ Because they have different risks, you can demand different returns. The higher the risk, the higher the return.

There are so many mutual funds in the market precisely because they reflect different asset classes. Then there are many professionals who have different investing ‘styles,’ which is basically a fancy term for what types of questions they ask and the research they do.

If you see mutual fund advertisements, you may think all mutual funds sound pretty convincing. But the reality is that some mutual funds are better managed than others. The reason is that the investment team likely has better research on what factors make businesses perform better, and they’re clearer on their philosophy and strategy.

While everyone will say they have an investment philosophy and skill to implement the strategy, the reality is that only some mutual funds can outperform the market index while others will end up delivering lower returns than the market index. Both underperformers and high performers will charge similar fees for their services. Ideally you don’t want to get stuck with mutual funds that underperform the index – not only do you get a lower return than if you’d invested in an index fund, but you also end up paying for it.

The next problem is to solve is which mutual funds have the potential to outperform. That’s a whole other topic. I leave you some food for thought:

“It is well-known what a middleman is: he is a man who bamboozles one party and plunders the other.” – Benjamin Disraeli

**Mutual fund investments are subject to market risks, read all scheme related documents carefully

Hansi Mehrotra, CFA is a financial educator who writes and speaks on various platforms, getting named as a ‘Top Voice for Money and Finance’ on LinkedIn for 2015. Hansi has more than 20 years experience in financial services.

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