Difference between shares and mutual funds

by Manshu on November 8, 2011

in Investing for Beginners

The best way to understand shares and mutual fund is to look at them from the perspective of the company that issues them rather than an investor. This may sound counter – intuitive at first because almost everyone tries to figure out what they mean from the perspective of an investor but somehow I find it a lot easier to explain them from the other perspective, and I think it will work for you as well.

What are shares?

Let’s say I run a space tourism company and run trips to the moon. I have had a successful business so far but I need some Rs. 100 crores for further expansion and invest in technology that will help me launch space trips to the Mars.

I own this company and I can raise the money by either going to a bank for loan or raising money from the public by issuing them shares in my company which will guarantee them a share of ownership in the company.

Let’s say my whole company is valued at Rs 500 crores, and that means I can issue 20% of my company’s shares to the public at Rs. 100 crores.

This is essentially what an IPO or Initial Public Offering is where a company comes out with an offer of its shares to the general public for the first time. A Follow On Public Offer or FPO would be when my company comes to the market for a second time.

Now suppose I do the IPO of my company and you buy shares worth Rs. 5 crores in the IPO – that will give you ownership of 1% of my company with voting rights equivalent to 1% and rights on the profits of 1% of the company.

In real life, common investors hold a lot lesser than 1% of a company and that’s why you rarely ever think in these terms but when you own a share – this is exactly what you own.

After the IPO – the shares of my company will trade in a stock exchange like the NSE or BSE, and people can buy or sell the shares from the stock exchange. In order to buy or sell these shares they will need a stock trading account and a Demat account.

Now, you must remember that when you buy a share in the IPO or FPO you buy it from the company, but when you buy it later on in the stock exchange you buy it from another investor or trader like you and that’s the reason this is called a secondary market.

The next thing to remember is that while you will continue to hear that I own the company, that’s not entirely true – I own only 80% of the company, and the rest of the 20% is owned by other investors like you.

Sometimes when a fraud is committed at a company – you can hear people say why did he steal from his own company?

And the answer is because it was not his own company!

While he may be running the company, he may only be an owner of 25% of the shares, and thereby only 25% of the earnings, and therefore he never had a right to the other 75% of the profit.

The other silly thing that I’ve heard from time to time is when someone criticizes really rich people like Azim Premji for calling their wealth “paper wealth”.

What people like Premji mean is that the wealth reported by magazines is based on share price, and these share prices keep fluctuating so the wealth keeps fluctuating as well. And anyway most promoters don’t have any intention of selling their shares so it’s all on paper anyway. This is not an arrogant statement, it’s just based on the fact that wealth is calculated based on fluctuating share prices that’s all.

Now, let’s get back to our original example and say that you tell your wife about the shares you buy in my company for Rs. 5 crores, and she is furious with you and says that this is a hare brained idea, and that you can’t bet all your money in just one company that may blow up any time!

You realize your mistake because after all if my Mars mission doesn’t get successful my company will go bankrupt and that will render your investment worthless.

So, you sell Rs. 2.5 crores worth of shares on the stock exchange and get that cash. Now, remember me or my company never get this money, somebody else like you bought it from you.

Now, you take this money and buy shares of my competitor company who is planning trips to Venus and you are feeling pretty proud of yourself and go to tell your wife about your latest strategy.

She is of course furious with your whole obsession with the space travel industry and asks you what will happen if the whole industry fails and every company goes bust?

You’re hit by a lightning bolt as you think about real estate stocks and IT stocks before them, and you decide to buy more companies.

But you don’t have the time or patience to go through the thousands of companies listed on the stock exchange to select an investment worthy one from it.

What are Mutual Funds?

This is where mutual funds come in.

They take money from thousands of investors like you and invest in stocks on your behalf. They hold many companies so that even if one is gone – you don’t lose all of your money.

They charge you a fee to manage these funds, and that’s expressed as something called as an “Expense Ratio”. This is a percentage of assets that they can use to cover their expenses and make profits, and the lower this is the better it is.

Mutual funds buy shares of companies, and they can calculate the value of their holdings by aggregating all the shares they have, and at the end of every day they publish a number called Net Asset Value or NAV. This is the value of the fund and how much it is worth at that point in time.

You have to buy or sell mutual funds directly from the fund house, and you can’t buy or sell them from another investor on the stock market like shares of a company.

Mutual funds are based on themes and are of different types but the main idea behind them is that they are an investment vehicle that help you spread out your investments in the underlying theme or asset class.

Another thing about them is that mutual funds are actively or passively managed. Actively managed means that there will be a fund manager who buys and sells stocks actively, and looks out for opportunities to buy and sell in the market all the time.

Passively managed funds are funds that just follow an index like the Nifty or the Sensex, and don’t try anything fancy. They own the same stocks as the ratio of their index and are content with matching their returns.

These type of mutual funds were born because research shows that most active funds aren’t even able to beat an index so it just makes sense to bring out a lower cost option that at least matches the index returns. However, they still do a better job than owning a few shares on your own and risk blowing up your capital if one of the companies go bust.

I think this covers the basic differences between the two and here is another post that goes into more details on how mutual funds work if you are interested in learning more about them.

As always, questions and comments are most welcome!

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