Most of us understand the difference between trading and investment. While trading pertains to the short term investments pertain to the long term. That is when you are talking about trading vs investing in stocks. People normally ask which is better trading or investing; and frankly there are no clear answers to question. However, it has been seen that over a longer time frame investing tends to work better than trading due to lower costs and greater power of compounding. In this piece we focus on something related but slightly different. Did you know that there is a difference between buying a stock and creating a portfolio? Understanding this difference is critical to your understanding of investing.
Buying a stock versus creating a portfolio..
Buying a stock refers to your decision to take a position in a stock after doing in-depth research. You have seen the fundamentals and the technicals and are convinced that the stock is a great bet. When you create a portfolio you not only look at the quality of the stocks in the portfolio but also look at how these stocks are correlated to one another as that is important to the risk of the portfolio. Here are 6 ways in which buying a stock is different from a creating portfolio.
1. Every stock is not necessarily related to your goals. You buy a stock because you see fundamental value in the business of the company. Additionally, the P/E may be very attractive and you may also see a veritable dividend play. When you create a portfolio you start off with your financial goals in mind. For example, if you need to grow your wealth by 15-16% annually over 25 years then equity is the best option. But if you want to earn around 7% per annum over the next 10 years then debt makes a lower risk proposition in your portfolio. You cannot create a portfolio without keep your goals as the nucleus of your decision.
2. Equities are a discrete choice; portfolio is not a discrete choice. When you have an allocation of Rs.5 lakh, you can choose to buy either Reliance or Larsen & Toubro based on your analysis of the future prospects of these companies. In case of a portfolio, there are not discrete choices. The attempt while creating a portfolio is to accommodate all alternative choices in the best manner possible. Portfolios do not believe in discrete choices and are more about combinations.
3. Stocks being discrete are not about diversification. When you take a call on buying Reliance or L&T your choice is a discrete choice. When you are creating a portfolio the correlation between the stocks you hold matters a lot. For example, if you are already holding 25% of your portfolio in financials, then the portfolio question will be whether to buy one more financial stock or not. From a stock perspective it may make sense but from a portfolio perspective it is only leading to substitution of risk rather than reductio of risk which is the core purpose of creating a portfolio.
4. That brings us to the next difference which is that portfolios are about managing risk and therefore they are about risk tolerance. When you take a call on buy a realty stock versus a banking stock, you are not overly looking at your risk tolerance. The focus in this case is more on the relative merits of the stocks. When you create a portfolio a few interesting questions come up. Does the stock fit into my overall risk profile? Is the stock adding to the risk of my portfolio or is it reducing the overall risk of the portfolio? What is the correlation of returns of the stock with my existing portfolio? Is the stock leading to a stretch on my equity exposure or sectoral exposure or thematic exposure?
5. Stock selection is more about specific equities. They do not look at other asset classes. When you are choosing between DLF and Sobha Developers you do not really worry about the returns you will get in a REIT or an InvIT or for that matter in gold. Portfolio approach is a more holistic view. It looks at a variety of asset classes beyond equity and that includes debt, mutual funds, hybrids, structured products, gold, REITS, InvITs, passive funds etc.
6. Lastly, it needs to be remembered that selecting a stock and creating a portfolio are not 2 entirely discrete activities. In fact, one leads to the other. Selecting the best stocks is just one of the steps of portfolio creation. Once individual stocks and bonds and mutual funds are selected, they are run through the test of portfolio fit before a purchase decision is made. That, probably, puts things in perspective!