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!

This post was from the Suggest a Topic page.

{ 56 comments… read them below or add one }

Karthikeyan November 8, 2011 at 11:00 AM

Dear Manshu,

This explains us clearly about the difference between the MF and Shares… It was very useful.

Thanks

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Manshu November 8, 2011 at 8:57 PM

Awesome – I’m happy to see such a lot of feedback on this topic, motivates to write more about these type of simpler topics in the future as well.

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DSI November 8, 2011 at 11:57 AM

Thank you for that lucid explanation. Quite a good primer for financial tenderfoots like me!

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Manshu November 8, 2011 at 8:56 PM

Great – glad to get good feedback on this post.

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Mithlesh November 8, 2011 at 12:18 PM

Hey Manshu!!

All i can say is awesome post again. I really wonder what motivates you to put in so much time and effort to help poor retail investors make informed decisions. Much appreciated !

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Manshu November 8, 2011 at 8:56 PM

Thank you Mithlesh – you are so very kind. I hope that wood-sculpture becomes a really popular website one day and that quite honestly is a big motivator 🙂

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bemoneyaware November 8, 2011 at 12:54 PM

Thanks for sharing information which is mutually beneficial.
Very basic apt for those who are starting investing.

As you have used word “secondary market” filling in for “primary market”.
Primarily there are two types of stock markets – the primary market and the secondary market. Basically the primary market is the place where the shares are issued for the first time. So when a company is getting listed for the first time at the stock exchange and issuing shares – this process is undertaken at the primary market and is called Initial Public Offering or IPO .

Manshu, a doubt-company gets money on listing in stock exchange but in secondary market it is just the exchange between the two investors..company does not get money only shares are transferred. Am I on right track?

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Manshu November 8, 2011 at 8:52 PM

Yes, you’re right – when a company comes out with an IPO and people apply for it – that money is blocked in their accounts first, and then when the stocks are allotted – the money is debited from their banks.

So, the initial stocks are bought by the investors and money received by the company before trading on the exchange starts.

When trading starts – that happens between people who have been allotted the shares, and no new shares enter the market at the time.

I’ve actually not used the word secondary market to fill in for primary market, but to highlight that the stock exchange is a secondary market and whenever you buy a stock from the stock exchange you are buying it second hand from another investor instead of the company.

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bemoneyaware November 9, 2011 at 3:01 AM

Quoting 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.
I thought, You had explained secondary market but there was no mention of primary market which basically means IPO/FPO. Hence wanted to add info regarding that. You did not fill in secondary market for primary. Was I wrong in thinking so?..if yes I apologize.

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Manshu November 9, 2011 at 6:02 AM

Oh okay – I’m sorry I didn’t get that – I thought you were saying that I am using secondary market instead of primary market for some reason. Sorry about that.

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Sumant November 8, 2011 at 6:13 PM

brilliant article (as always!).

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Manshu November 8, 2011 at 8:47 PM

delighted to hear that 🙂

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khalid November 8, 2011 at 8:17 PM

Very clearly explained the difference between shares and mutual fund. Example of Moon and Mars is very interesting. Thanks for sharing.

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Manshu November 8, 2011 at 8:44 PM

Glad to see you here after such a long time. The topic was fairly straightforward so I wanted to make it a bit interesting and take some interesting examples 🙂

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bemoneyaware November 9, 2011 at 2:57 AM

You mentioned 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. This is where mutual funds come in.

With 5000+ MF schemes available and different flavors(Large cap, Diversified, Mid Cap, Small Cap, Debt, Liquid, FMP, ETF, Gold..) choosing a MF also is not an easy task these days.

And as there are no free lunches in life, MF charge for the so-called convenience that they offer.
Does it really make sense to invest in MF then? Why does it score over Stocks?

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Manshu November 9, 2011 at 6:08 AM

This comment is very timely for me because just before reading this I was going through a thread that I discovered as a result of the trackback on this page. Do you see the link under the “1 Trackback” near the bottom of this page?

Just click that and spend some time reading that thread.

That guy is trying to find stock tips by asking questions on a forum thread! Unfortunately, when it comes to stocks most people think of it as gambling and then buy two or three stocks with which they burn their hands.

That’s why I feel that for the majority investing in diversified mutual funds is better. That doesn’t mean everyone should do it – but I think most people are better off starting like that.

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bemoneyaware November 11, 2011 at 3:01 AM

Checked the trackback and was not shocked. Everyday I pick up a Financial newspaper, magazine or switch on TV I see people asking for tips to invest. Everyone is looking for a shortcut to become rich. We don’t allow people to drive without taking a driving test but allow them to enter the complex financial world without any financial education It’s like saying “Bache tu pal hi jaate hain” Ask a parent how much effort, time it goes in raising a well balanced child. Sadly in life there are no free lunches and what you sow you shall reap.

You mentioned that MFs are be a safer option compared to Stocks for the convenience they offer and MFs are diversified in nature etc. Which is partly true. But would investing in a fund such as LIC Nomura MF Opportunities which has given a 5 year return of just 0.81 serve any purpose.

Giving a simple analogy: We all know we eat food to sustain our body and we need a balanced diet. But do most of people understand it: The rise of obese people do not say so.

All I want to say is MFs is not the Holy Grail. One needs to invest in it with eyes open. And it’s not like “Buy it, Forget it” One needs to continually review it. Reliance Growth, SBI Contra which were the stars of the MFs few years back are under performing these days .

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Manshu November 12, 2011 at 8:35 PM

Yes i absolutely agree. It is not the holy grail and you need to be careful with what you have invested.

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prav November 10, 2011 at 3:33 PM

Hi, Thanks for the article. Could you explain how the stock prices rise/fall.. I know its based on company performance and the economy etc. But really, what does someone get out of paying a higher price for a share?

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Manshu November 10, 2011 at 8:04 PM

They key to understand this and sometimes it takes people years to understand this is that stock values depend on valuation and valuation is a matter of opinion.

The facts are the same but that’s in the history, the future is what people bet prices on and everyone has a different view on the future. So, someone pays a higher price for a share they are saying that they believe that the stock is still undervalued relative to the earnings in the future.

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bemoneyaware November 11, 2011 at 2:46 AM

What affects the stock price? A good question and answered by Prav himself. Just expanding on it.
In the long run, share prices are heavily influenced by earnings. When companies make money, consistently over long periods, investor confidence grows and bid the price of shares up. Ex:Infosys.
Over shorter time frames, influences become even more numerous and harder to quantify. Everything from the latest analyst recommendation and rumor or actual news event, to fraud – the herd mentality and a blizzard of technical factors plays a part. Political changes play a part, and sometimes they too are unexpected by most investors. Ex: UPA returning to power for second term

Share prices today are in large part due to expectations of what the price will be tomorrow, next month or next year.

Coming to second part of the question: Why will someone buy at higher price?
Simple answer: To sell it someone at a still higher price. After all people invest in stocks for making a profit.

There are various theories regarding investing, one of them is Greater Fool Theory
The greater fool theory proposes that you can profit from investing as long as there is a greater fool than yourself to buy the investment at a higher price. This means that you could make money from an overpriced stock as long as someone else is willing to pay more to buy it from you.

Eventually you run out of fools as the market for any investment overheats. Investing according to the greater fool theory means ignoring valuations, earning reports and all the other data. Ignoring data is as risky as paying too much attention to it; so people ascribing to the greater fool theory could be left holding the short end of the stick after a market correction.

Read more at Investopedia:7 Controversial Investing Theories

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Vijay November 14, 2011 at 1:07 PM

Nice detailed reply bemoneyaware !!!

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Chirag November 11, 2011 at 5:26 PM

A detailed indepth article.
Nice one.

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Manshu November 12, 2011 at 8:30 PM

Thanks Chirag.

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Vijay November 12, 2011 at 11:14 PM

Nice post Manshu ! I read a statement a year ago which always rings in my ears whenever i read an article on the basics of MF investing – ‘MF is a vehicle to invest in the stock market’ – tis like using a boat to cross the river than swimming yourself !!!
Now, a question.
1.It is repeated ad nauseam whenever an NFO offer of a new MF (which claims to be offering a unit with NAV of Rs 10/-! as usual) that one should not jump at it.
2.Whenever one wants to invest in a MF, it is always mentioned that one should ideally look at 5 year returns, AUM, Fund Manager, Large Cap vs Mid Cap and so on.
3.Whenever results of a MF which has been performing well are analysed, it is concluded that if a person had invested in 2005, his present returns (in 2011) would have been x % or so !!!!
So, my Question is how does one pick the Mutual Fund which is going to perform well, at the very early stage i.e within a couple of years of its inception? when it doesn’t have 5 year returns to boast, its AUM is unlikely to be great, and its fund manager might not be a famous guy????
Otherwise, everyone would be investing only in MFs atleast 5 years after their inception so that they invest in a tested and trusted one !!!

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Manshu November 13, 2011 at 8:36 PM

In my opinion a fund with a track record is the best bet. There is just not much else to go by.

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bemoneyaware November 14, 2011 at 10:46 AM

Good question Vijay and my two cents on it.
Let’s just take an analogy(without going into details..as to whether it is legal or whether you would do it).
Asked to bet between who would score more runs in a cricket match -Sachin Tendulakar or Virat Kohli or Ajinkya Rahane
Or whose movie will run a Khan(Shahrukh/Aamir/Salman) v/s Himesh Reshimya or Paswan ?
Whom would you choose and why?
My money would be on Sachin Tendular(Khan) for simple reason his past performance, his big scores.
Coming back to Mutual Funds and NFO, NFOs catch attention as they are advertised a lot. In 2007 Reliance Equity NFO collects Rs 2,700 crore was one of the big news. It is now renamed to Reliance Top 200 Fund. Source It’s returns are decent.
The fund JM Contra Fund was launched with great fanfare under Mr. Sandeep Sabbarwal who had done wonders to SBI Contra Fund. Now it has been merged into JM Multi Strategy Fund with effect from April 1 2011. It’s returns were always negative.
Existing funds can also loose money. Checkout
ET on investing in JM Basic
You have to be careful while investing in the existing or a new fund, its your money after all :-).
You have to know why you are investing, which fund you are investing(Equity Diversified, Small Cap, Hybrid, Sector), and then track the performance of the fund..

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Vijay November 14, 2011 at 1:04 PM

Point noted very well ! But my question was that when everyone relies only on tried and tested MFs, why is it that during the analysis, people write as if one had invested in this fund much earlier, you could have made a killing !!!

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bemoneyaware November 14, 2011 at 5:16 PM

Sorry I went on the track of explaining why the past performance should be used.
Another attempt in answering your question:
Because hind sight is always 20-20. It is easy to say/safe to say what should have been done then to say what to do :-).

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Vijay November 14, 2011 at 10:42 PM

So true!!!

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Manshu November 15, 2011 at 12:11 AM

Same reason people say you should be greedy when everyone else is fearful and fearful when everyone else is greedy. When there is panic, most punters and investors are found hiding under their bed rather than buying greedily on the stock exchange.

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bemoneyaware November 15, 2011 at 3:06 AM

I think Warren Buffet said “you should be greedy when everyone else is fearful and fearful when everyone else is greedy”. And we all know what a legendary investor he is.

And I think people in stock market follow herd mentality like : Stampeding up the high mountain when markets are rising and down into the cold deep sea when markets are falling! Psychology of a Market Cycle explains it beautifully.

Extreme optimism can coincide with market tops. People think the sky’s the limit and send stock prices flying. Savvier investors sell into this frenzy and run to cash. The market tanks soon afterward!

Extreme pessimism can be bullish. Toward the end of a big decline, the last bulls throw in the towel and sell with a vengeance. Cooler heads smell a fire sale. They dive into the market and buy equities with both hands to launch the next rally!

Actually it all boils down to preparation, awareness and control

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Manshu November 15, 2011 at 4:32 AM

It’s repeated so often by so many people that it frustrates me a little bit. I’m sure if you were to do a quick search of this blog itself you would find quite a few examples. I’m fairly certain most of the people who say it aren’t able to follow the maxim at all. How many people are really buying now? How many people were buying a month ago?

Another one of those easier said than done thing.

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bemoneyaware November 15, 2011 at 10:01 AM

Yup you are right. Using an analogy We know one should exercise everyday. For if you make no time for exercise you make time for illness. But how many of us follow. Those who follow not only build a healthy present but a healthy future too. Those who will do what they learn from such forums will reap great benefits for we all know “What we sow we shall reap”. And this is what separates Men from boys and legendary investors like Buffet for ordinary ones.

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raju August 26, 2012 at 10:23 AM

I really like your article about mutual fund and shares.I am facing problem to understand these topics but you have given good example related to that and try to keep on.student like me(Invoice) is very tough to undestand all these stuffs

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Manshu August 28, 2012 at 5:41 AM

Thanks!

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saheli December 27, 2012 at 6:08 PM

thanxs dear… for ur nice explanation…frankly speaking I always used to mix up both the things and could never find the exact explanation and difference. this is for the 1st time in my life I get to know these things…its now crystal clear…thank u once again…
one thing more..I would love to have such gud explanation in some other financial field specially in banking…please do write….thank u..

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Pradeep February 4, 2013 at 11:58 AM

Hi…
Thank u for providing us the valuable information.
As a beginner…. I have few doubt’s….
1. How to chose a company before investing in share market?
2. What are the factors that should be taken into consideration before investing?
3. What is SIP?

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purshotham reddy February 10, 2013 at 3:46 PM

it is very clear

thank u

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Manshu February 11, 2013 at 3:52 AM

You are welcome and thanks for your comment.

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sai March 29, 2013 at 3:16 PM

Good Post, every one can understand easily

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Manshu March 29, 2013 at 8:54 PM

Thank you.

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Sindhu Gopinath N April 12, 2013 at 11:30 AM

for long I hadnt got the concept of shares; but now I too can explain the concept to someone!
Explanation is at its best.

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Manshu April 14, 2013 at 7:38 PM

Thank you Sindhu, please post any questions that you may have about this or any other financial topic and I will try to answer them.

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Aman Arora October 1, 2013 at 1:58 PM

Mate Your Articles Have Been Awesome.

I Need Help Understanding Why The Rupee keeps Falling Against The Dollar.?

I Never Seem To Understand It Completely.

Great Article on The Capitalist Economy Also. Thumbs Up Mate.

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Isa Khan September 1, 2014 at 11:37 AM

Great job Manshu.
I have read about mutual funds at various websites including Wikipedia.
But, this has been the best explanation so far.
And now I can say that I have understood clearly what Mutual Funds are.
P.S. I love your example
Keep up the good work and keep educating us.
Thanks 🙂

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neeraj October 27, 2014 at 10:20 PM

Economics through examples is very easy to grab…thanks a lot….

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lakshmi December 3, 2014 at 10:35 PM

Manshu,
Shares was my Achilles heel and now because of your spilled bean I am able to understand. A big thanks. (y)

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anmol December 8, 2014 at 1:40 PM

this is my first time anybody cleared me the meaning of stocks and mutuals this was amazing post and its being years clearing the cossept of it.this is the firs time anybody cleared it in mylife.

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farhana January 19, 2015 at 1:59 PM

very useful article..thanks alot sir!!

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nishant Kumar Gupta July 1, 2015 at 4:20 PM

I m well satisfied

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Haritha Bhaskar August 12, 2015 at 6:35 AM

Your article was really superb sir…
Can you please explain the passive mutual funds…

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Gayathri November 18, 2015 at 9:13 PM

Thank you for your explanation sir….iam completely satisfied

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Murali November 30, 2015 at 2:04 PM

Thanks Very Useful

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Dev rajpoot January 31, 2016 at 8:13 PM

I’m 21 years old and I want to invest in shares or mutual funds but I don’t understand how it works . can u help me ?

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peluang bisnis March 7, 2016 at 8:42 AM

I’m impressed, I must say. Seldom do I encounter a blog that’s
both equally educative and interesting, and without a doubt, you’ve hit the nail
on the head. The issue is something not enough folks are speaking
intelligently about. I’m very happy that I found this during my search for something regarding this.

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