Stocks/Equity:

A Stock market is a place where we can buy and sell holdings/shares (or ownership) in one or more companies. The stock price of a company depends on how well its growth is. But this is not the case always. So if I buy a share at a low price and after some time, if I can sell the share at a higher price, then the difference is my profit. The place where the companies are listed (where we can buy/sell) is the stock exchange. There are two exchanges in India, namely, NSE (National Stock Exchange) and BSE (Bombay Stock Exchange).

It isn’t possible for us to always invest in the stocks that will give good returns. We have to agree we will make mistakes and lose money. Also, the most important lesson is, we can never predict how a company will do in the short term. But with the right education and right experience, we will be able to predict a companies’ behavior in the long term. Hence the famous statement, Investment is always a long-term game. Anything below 5-10 years is not an Investment.

Investing in stocks gives higher returns when compared to investing money in gold, PF, FD, RD, PPF. But as always, higher returns mean higher risk. To become a good investor in the stock market, we need the following things:

To learn about the workings of the stock market. Understanding it as a system.
Before investing in any company, we have to spend a lot of time understanding their financial standings.

Becoming good at something will take time, and I certainly won’t start at a point where the stakes are high because there is a high chance of making mistakes. To avoid this problem, we better seek professionals for help. When we have enough understanding, we can start to emulate them and later adjust things according to our taste.

Mutual Funds:

A mutual fund house is a company that provides the following services. It has experts in the stock market called fund managers. So we will pay them for helping us to get better returns. It’s like we hire an expert to do our work (efficiently manage to invest our money in the market) for their service we pay a charge called the Expense ratio.

So in this scenario, we don’t play with high stakes without enough education/expertise. So we are playing a much safer bet now. Thus we buy ourselves some time to learn about equity while our money is earning in the meanwhile.

Now we have traded our time for the fund manager charges (Expense ratio). So we don’t have to monitor the market constantly and buy/sell the shares as if we are managing the stocks. We can check how the fund is doing once every 3/6 months. We have saved a lot of time.

Now how do funds work? An expert collects money from multiple people for buying one/more shares. The expert also manages the share/money. There are funds for equity, gold, bonds, etc. There are two types of funds,

Actively managed fund
Passively managed fund.

A fund manager will constantly monitor actively managed funds. So the expense ratio, in this case, will be higher when compared to a passively managed fund. Also, the return/risk is also higher for actively managed funds. These funds a mainly classified into three types as follows (however, there are many more types that I have avoided for simplicity!)

Large Cap - The fund manager will invest in strongly performing companies. The ones which are at the top of the NSE/BSE listing. So the returns/risk will be minimum.
Mid Cap - The fund manager will invest in middle-level companies, these might contain emerging companies. So the return/risk is higher than what we saw in Large Cap.
Small Cap - The fund manager will invest in small level companies, for example, these might have startups. So the return/risk is very high in these funds.

Fund managers will not constantly monitor passively managed funds. Here the fund manager invests in much safer stocks so that the returns/risk is not as high as an actively managed fund. Hence the expense ratio is much less.

Experts are constantly fighting against the market to beat it. But eventually, they will lose because this is a zero-sum game. So we must monitor an actively managed fund once every 3/6 months to guarantee it gives better returns than the index.

Each fund is measured against the index benchmark. If an actively managed fund gives a return percentage that is less than the index (after reducing the expense ratio) then that fund is not good enough.

Index Fund:

An index fund is a type of passively managed fund. SEBI has made sure every fund will be measured against an index fund. So that, we the investors can have a measure of how well the fund is performing.

A few examples of index funds are listed below

Nifty 50 - A fund that contains top 50 companies in NSE.
Nifty Next 50 - A fund that contains companies from 51 to 100 in NSE
Nifty 100 - A fund that contains top 100 companies in NSE
BSE 500 - A fund that contains top 500 companies in BSE

The point in an index fund is, we will always have holdings in the top-performing companies. I will explain this statement with an example, say if we are holding Nifty 50, that means we are holding shares in top-50 companies of NSE. Tomorrow say a company called X who is currently in 50th place moves to 51st position in NSE listing and a company called Y moves from 51st place to 50th place, then automatically our holdings from X is sold and we will buy holdings in Y. So it is like having holdings in the top-50 companies anytime, it doesn’t matter who it is! These are taken care of by machines/code without any manual intervention. Hence the expense ratio is much less when compared to our actively managed mutual funds.