A primer on investment risk
Many investors anxiously jump right to stock selection when constructing a portfolio. But understanding and controlling for risk is at least as important as choosing the right investments. And while risk cannot be completely avoided, it can be understood and limited during the portfolio management process.
It is axiomatic that all investments carry a certain level of risk. Investors typically think in terms of the potential for suffering losses, but a better definition of risk is the level of uncertainty or potential for deviation from expectations surrounding a particular investment selection. Some investment choices clearly involve substantial uncertainty, like a tech start-up firm or a small biotech company with a new but unproven medication in clinical trials. In such cases, investors may be willing to shoulder the potential for losses in exchange for the possibility of large gains.
Some investments are generally considered low-risk alternatives, like U.S. government or high-grade corporate bonds. In such cases, the risk of loss in principal and interest is near zero. However, other forms of risk inhere in such instruments; for example, inflation risk. A “safe” Government bond with a relatively long maturity could prove costly in terms of lost purchasing power in an inflationary environment. Furthermore, when interest rates rise, other alternatives become more attractive and diminish the relative value of existing bonds. The bottom line is that all investments necessarily involve some risk which must be understood and addressed by investors.
It turns out that when Grandma advised you not to put all your eggs in one basket, she actually was expressing an enduring tenet of modern finance: diversification reduces overall risk. One can combine several investments, each possessing considerable risk individually, into a portfolio with lower aggregate uncertainty but still offering satisfactory potential for return. And it turns out that the number of individual securities need not run into the hundreds to accomplish the task. Chosen properly, a couple of dozen positions can do the trick.
The magic of diversification depends upon the interaction of individual selections within a portfolio. Suppose you purchase shares of Ford Motor Co. As with all cyclical businesses, Ford’s fortunes rise and fall over time in response to various factors. Adding another similar holding like General Motors does little to reduce overall risk. But combining a relatively uncorrelated stock (say Colgate or Kraft Foods) dilutes the potential negative impact from a decline in car sales or a spike in auto loan rates. Using the principle of diversification, stock-level risk (called “idiosyncratic” or “stand-alone” risk) can be nearly eliminated through judicious selection of uncorrelated companies. At that point, the investor is left with the inherent risk attendant to being invested in stocks generally. This is known as “market” or “systematic” risk, and can best be visualized by considering the uncertainty in holding a broad market index fund, like the S&P 500. Very little impact if one stock blows up, but 100 percent of the downside if the whole market tanks.
Taking the concept a step further involves bringing in other asset classes. Adding bonds to a stock portfolio diversifies away some of the systemic risk of the broad stock market. Similarly, other classes like foreign stocks, small-caps, and real estate tend to further mitigate systemic risk when added to a portfolio even though some of those assets may have quite significant uncertainty when standing alone.
In the end, prudent management of investment portfolios involves not just skillful selection of individual securities. It also requires an understanding of various risk characteristics of the investments and an effort to moderate volatility where possible through diversification of assets and asset classes.