A hidden tax advantage of mutual fund.

Hello ladies and gentlemen, this post is about wealth.

A friend of mine was asking for my advice on investing, he wanted to start investing directly in to share market. As I was a sub broker in stock market before, I knew the futility of trying to teach stock investing to people who are past 35 yrs age. But he was a good friend of mine.

So instead of teaching him I just adviced to go with a mutual fund. He asked for the advantages of mutual fund over direct investing through demat account.

It was the first time I was asked this question. I just used mutual fund to invest only a part of my investment for diversification. So I started thinking. And it clicked that there is a hidden tax advantage, particularly with the growth option of the mutual fund scheme.

Generally we only notice the things which we can see or experience, but don't notice those which doesn't happen. In psychological terms, it is called availability bias. (We only see or consider what is available in front of us.) For example surviver of a fatal accident like a building collapse might tell that he only recited god's name and hence he survived. And we just remember this that reciting god's name will save us. But we don't think about what the dead people did before death in the same accident? There is no way to know but certainly, of they believed in God then there is a high probability of them reciting the god's name. But still they died.

In the same way we can't easily notice the hidden tax advantage of mutual fund.

When we invest directly in the stock market, we generally creat a portfolio of stocks. When we think a particular stock say x has appreciated in price too much than the fundamental valuation of the company or the growth potential of the company. (In simple terms you regularly use a particular brand of pen that you purchase for 10 bucks, and you know the pen is worth only 10 bucks and one day a stranger comes and he notices the pen, likes it way more and offers 100 bucks for it. Obviously you will sell it and go to your regular shop and purchase a new one for 10 bucks.) Though it sounds crazy but it regularly happens in the market, or the opposite also happens in the market, like, a person have bought the same pen but doesn't liked it, so now he is trying to get rid of it for 5 bucks.(shares are not always perfectly priced in the stock market or in other words, share market has inefficiencies at most of the times.)

So you will do the same thing in stock market, that is sell the overpriced company share and purchase an underpriced company share.

But when you sell the overpriced share you will book the profit and for this profit you have to pay the capital gains tax.

Mutual funds also construct a portfolio of investments, sells the overpriced investments and buys the underpriced investments. But a mutual fund doesn't pay tax on the profit booked. It's unit holder has to pay tax when he gets profit from the mutual fund, that is when he gets the dividend on the mutual fund units he holds (dividend option) or when he sells the mutual fund.

If one has purchased the growth option of mutual fund then he only books the profit when he sells the mutual fund units. So for the holder of growth option mutual fund units, he can defer booking profit and thereby the capital gains tax as long as he wants.

That is, if you invest directly (purchase individual shares), then each year your investments are reduced by the tax you pay while in the growth option mutual fund units you get to use this capital gains tax money until you book profits. Even if this gain is only 1% of the investments per year in 40 years it will creat a compounding gain of 48.8%.

So if your stock picking skills are not better than a professional fund manager and don't have the resources (time for research, strong will and capacity to learn) then investing in the growth option of a good mutual fund for long term is a good profitable option for you.

Thank you and have a nice day.

Sumit,

The POWER is when,
You use ODDS,
To get EVEN.