There’s no such thing as a free lunch. The same holds constant for stock investments. If a portfolio manager states that he can guarantee you returns of 10% per annum he is a flat out liar. This is because every equity investment holds the risk of loss in principal. If your expected return is 10% it is because you are bearing more risk than an investment with an expected return of 5%.

There are two main types of risk you should know about. They are unsystematic and systematic risk. Unsystematic, also known as firm-specific or diversifiable, risk is the volatility in your portfolio returns due to factors that are unique to a specific sector or company. Daily return computations capture firm-specific volatility. This is because there is greater variation in daily returns as opposed to monthly or annual returns. You can essentially eliminate this risk with a portfolio of around 40 different stocks (in different asset classes). Systematic risk is the variation in returns due to market risk. These risks include things like unemployment, inflation, economic shocks, and other macro-level occurrences. You cannot get rid of market risk.

Effective diversification lowers your portfolio’s standard deviation (we will ignore tail risk and assume a normal distribution). Why so? This is because the correlation coefficient varies with each individual stock. If two stocks have a correlation equal to one, they have perfect positive correlation and will move together. A correlation equal to zero means there is no relationship at all in the gains and losses. A correlation of negative one means when one stock goes up one percent the other goes down one percent (correlation is between -1 and 1). Since no stock is perfectly correlated with another stock (if you diversify correctly), your portfolio’s standard deviation will consequently decrease. However, over the past decade, the stock market as a whole has become increasingly correlated. This is because of the high demand for ETFs (exchange-traded funds). ETFs are an inexpensive way to minimize unsystematic risk. Unfortunately, this leads to stocks within an ETF being bought and sold not on the fundamentals and performance of a certain stock, but because an investor wants to get rid of his firm-specific risk.

Systematic risk should not be confused with systemic risk. Systemic risk is too-big-to-fail risk. Basically an entity is intertwined with others and the failure of one will lead to a domino effect of failures. The financial crisis of 2008 is a perfect example. When Lehman went under, Goldman Sachs and other investment banks had large holdings in the insolvent firm. If it wasn’t for a government bailout these banks, and the economy, would have collapsed due to an illiquidity trap. The total risk of a financial instrument is the sum of the systematic and unsystematic risk.

Article By:

David Howard