fbpx

Blog

Failing to Diversify – Chances Are It’s a Raw Deal

In almost all areas of life, we have to give up something to get something.  In doing so, we want to receive a reward that is at least equal to what we give up.  For the time, effort and skill we provide to our employers, we expect to be compensated commensurate to the value of that time, effort, and skill.  When we purchase personal items (such as cars, clothing, furniture, vacations, etc.), even though most of them decrease in monetary value over time we expect that we will derive utility and enjoyment from them that a least justifies the purchase price and the depreciation.  Finally, at the risk of sounding cynical, even when we volunteer or donate to a charity, is it because we are doing good for others or is it the feeling we get from doing good for others?

That last may be more of a question for a philosopher than for an investment analyst, but the point is that in almost all areas of life we expect to receive something of value for what we give up.  In investing, what we seek is to increase the value of our investment as much as possible, and what we “pay” for that possibility is the risk we take – the risk that the investment will decline in value or will at least fluctuate in value.  Investments that carry greater potential for high returns generally require the investor to assume greater risk of loss, or volatility.  In other words, the investor has to “pay” for the possibility of higher returns by accepting more risk/volatility.  A “rational” (as defined in the field of economics) investor expects to be properly compensated, with the potential of a given return, for the amount of risk he or she takes on.

There are two main categories of risk that an investor faces.  The first type, systematic risk, is the risk that is inherent in the securities markets as a whole.  This risk is affected by macroeconomic factors, such as GDP growth, interest rates, taxes and government regulation, and employment rates.  The second type, unsystematic risk, is the risk that is specific to an individual company, industry, or even sector.  Examples are a company’s profitability, the quality of its management, conditions in its specific industry and market, and negative publicity concerning the company.  So an investor is exposed to more unsystematic risk the more his or her portfolio is invested in a single security or a few securities.

There is a very important distinction to be made between the two types of risk.  On average and in the long run, an investor is not compensated (with higher returns) for assuming unsystematic risk.  Conversely, on average and in the long run, an investor is only compensated (with higher returns) by assuming systematic risk.  Putting it another way, an investor probably is not getting what he or she “pays for” by taking on unsystematic risk.

The logical course of action for the “rational” investor is to remove unsystematic risk from his or her portfolio.  Fortunately this is easily accomplished through proper diversification; this is far easier to achieve with mutual funds/ETFs than with individual securities.   It is important to note, however, that having a large number of holdings, by itself, does not necessarily mean that a portfolio is properly diversified.  If the mutual funds/ETFs all are of the same style (large cap growth, for example), then the portfolio is still not sufficiently diversified and is thus subject to unsystematic risk. Therefore, portfolio composition should be constructed with the help of a financial advisor with the knowledge to perform a thorough analysis of individual holdings.  By contrast, systematic risk cannot be removed through diversification as it is inherent in the market as a whole.  However, as noted previously, only systematic risk will, on average and in the long run, compensate the investor with long-term returns.

Large, concentrated positions in individual securities (along with the unsystematic risk they bring) are often retained by investors for various reasons, mostly unrelated to investment fundamentals, asset allocation, and portfolio construction.  Examples are a sentimental attachment to a stock that was inherited from a loved one, a large holding of employer stock in a retirement plan held due to loyalty to the employer, some other personal affinity to the company, or a desire to avoid realizing large capital gains.  In the case of employer stock, it should further be noted that an investor is not only exposed to the company through the stock but also through his or her job (“Exhibit A” being those who worked for Enron).

Investors that choose to retain such holdings would do well to examine their reasons for doing so and decide whether the benefit they are deriving (saving on taxes, or avoiding feeling disloyal to an employer or loved one) is worth the unsystematic risk they are taking on.  Chances are, they are not “getting what they are paying for” when the investment is viewed purely from a risk/return perspective.  This can only be remedied by diversifying the concentrated holding.

 

Sources:

http://www.investopedia.com/walkthrough/corporate-finance/4/return-risk/systematic-risk.aspx

http://www.investopedia.com/terms/u/unsystematicrisk.asp

http://www.investinganswers.com/financial-dictionary/optionsderivatives/systematic-risk-1099

http://en.wikipedia.org/wiki/Systematic_risk

http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/RetirementAccounts/p013381

https://online.citibank.com/US/JRS/pandt/article.do?ID=JC45

http://www.forbes.com/sites/cfainstitute/2011/12/21/three-behavioral-biases-that-can-affect-your-investment-performance/2/

http://www.nytimes.com/2002/01/20/us/enron-s-collapse-workers-workers-feel-pain-layoffs-added-sting-betrayal.html

http://www.nytimes.com/2001/11/22/business/employees-retirement-plan-is-a-victim-as-enron-tumbles.html

http://news.morningstar.com/classroom2/course.asp?docId=145385&page=4&CN