An equity MF is like a branded hotel chain

One also has the option of checking into a hotel run by a hotel chain. And many people choose to do just that. Such people do understand that there might be better local hotels going around, nonetheless, they still choose to go with a hotel chain. Such individuals are essentially trying to reduce what economist Thomas Sowell refers to as the range of uncertainty.

As an outsider going to a holiday destination, one doesn’t really know the quality of different local hotels. Of course, there are enough travel review websites going around. But going through these websites needs time, which one may not have. Hence, one needs the right kind of knowledge to make a perfect decision and that knowledge comes with the cost of time spent.

As Thomas Sowell writes in Knowledge and Decisions: “An experienced traveller who has been through a given area many times may be able to select local hotels, restaurants, and auto rental agencies much more advantageously than by relying on franchise names [like hotel chains].”

Nonetheless, all travellers don’t have this experience. Hence, it makes sense for them to reduce the uncertainty and go with a branded hotel chain where they know what to largely expect. This is the cost of the lack of knowledge. And it isn’t necessarily a bad thing because one is avoiding the risk of ending up staying in a really bad local hotel.

Interestingly, this concept can be applied to investing as well. Let’s say within half a kilometre of where you live, there is a cooperative bank and a commercial bank. The rate of interest offered on fixed deposits is higher at the cooperative bank than the commercial bank.

As an outsider, you just don’t have enough knowledge about the cooperative bank, whereas you know that a commercial bank is a safer option. Given this, it makes sense for you to go with the commercial bank. Of course, the lower interest on your fixed deposit is the cost of the lack of knowledge. If you had the time you could have figured out the financial state of the cooperative bank and possibly earned a higher rate of return.

A similar dynamic is at play when it comes to investing in stocks versus investing in equity mutual funds (MFs). For individual investors investing directly in stocks in the right way and not just following the next stock-tip that they get hold of, takes a lot of time and mental effort. The thing is they may be short on time and not capable enough to make the mental effort required to directly invest in a small portfolio of stocks and make good money from it.

This is the cost of the lack of knowledge. Nonetheless, they can still benefit from investing in stocks by investing indirectly through mutual funds. A mutual fund is like a branded hotel chain. It may not give you the best service, but you know you will get a decent service, on most days. The range of uncertainty which comes with direct investing in stocks is lower than when investing in stocks through a mutual fund.

In fact, we can take this argument even further when deciding on which kind of mutual fund to invest in. There are hundreds of equity mutual funds going around.

To figure out which one to invest in again requires time and mental effort. This is the cost of knowledge as has been explained earlier.

To get around this problem, one can simply invest in index funds and exchange traded funds (ETFs). Index funds invest in stocks that make up a stock market index like the Sensex or the Nifty. They invest in the same proportion as the proportion of a particular stock in the index.

Exchange traded funds are basically index funds which can be bought and sold on a stock market. These are not perfect choices but they are good enough and while investing this is something that we should keep in mind.

Vivek Kaul is the author of Bad Money.