Picking the right businesses to invest has also been a difficult task. There are many techniques and approaches to investment. Therefore, it gets somewhat confusing to select and follow a strategy. Questions like going all bounty for a stock or creating a portfolio of stocks, going for a penny stock or a well-established market leader, are always around the corner.
Did you know the difference between buying a stock and creating a portfolio?
Investing in a stock should be after having a complete understanding of the business of the Company. In-depth research and analysis of a company help the investor decide whether a particular stock could outperform the market return. The study consists of many things, including but not limited to, company’s viability, future profitability, scalability and sustainability in the dynamic environment. This type of approach where we first identify a particular company and analyse it entirely is known as a Bottom-up approach. Investors willing to invest in a specific stock prefer a bottom-up approach.
Unlike when the investor wishes to create a portfolio of multiple stocks, one may choose various businesses in diverse sectors which are less correlated to each other. Correlation is significant between the shares to minimise the overall portfolio risk. This type of approach is also known as the top-down approach. The investor would start by analysing the macro-economic indicators, identifying benefiting sectors and then identifying market leaders in those sectors.
Which approach is better – Stock specific or portfolio?
The stock-specific approach is preferable for active portfolio managers who understand the exposure to risks and allocation of capital. The stock-specific method generally has higher variability in terms of average returns. It tends to outperform the portfolio of stocks, i.e. higher returns than returns from a portfolio of stocks since the risk is also high. For passive investors and newbies, the portfolio approach should be preferred as it reduces the overall risk and allows the investor to stay in the game for a little longer. Here are the benefits of a portfolio approach to investing.
- Diversification – Diversification is a hedging tool which evens out losses from specific sectors with profitable ones and vice-versa. Hedging comes at a cost.
- Lower but Sustainable returns: The overall performance of the portfolio reduces when compared with a non-diversified portfolio or few selective stocks because of the diversification. As against this, the stock-specific approach has a more significant risk as a large percentage of the capital is employed in a single stock. Any underperformance of a particular stock has a substantial impact on the portfolio return. Further, a share is affected by the short-term fluctuations in the market, which may or may not equal to an investor’s potential losses. Portfolio approach offers stability in the returns.
- Long term Investing- Portfolio approach is all about having a long term outlook. It creates wealth over the years with consistent compounding of returns. A stock-specific approach may or may not have a longer outlook as the fundamentals of the business change and may not be very relevant considering the market dynamics.
- Lower Risk- A direct benefit of diversification is to reduce the overall portfolio risk. This happens because of the elimination of idiosyncratic risks or diversifiable risks or unsystematic risk. Unsystematic risk is the inherent risk specific to the Company or a particular industry. Such stock-specific risk drastically reduced through diversification by investing in a range of companies and industries. A portfolio is immune to this as it is well diversified.
- Compliments your financial goals- A portfolio compliments your financial goals such as early Retirement, Child Education etc. as it consists of all the stocks from different sectors. While a stock-specific approach would not help as a stock or industry may become obsolete until the time you reach your goal deadline. For, eg. The fuel industry may die after the introduction of electric-powered vehicles in the near 20 years.
‘The only certain thing today is uncertainty’. The business environment is dynamic, and the market dynamics are shifting gears constantly and hence, requires constant monitoring and action to manage the overall portfolio risk. Creating a diversified, long term portfolio may prove to be a better tool in this business environment over a single stock. StockBasket offers one such opportunity of portfolio of stocks analysed and selected by an experienced research team. StockBasket offers a readily available portfolio with minimum overall portfolio risk as well as aligned with the long term aspirational goals of the investor.