We’re about to dig into something a bit more technical than we usually discuss on this blog, but I promise it’s worth it. Understanding the concept can have a direct impact on your investment results.
Risk (in the finance-world sense of the term) can be broadly divided into two categories:
- Diversifiable risk, and
- Undiversifiable risk (also known as systematic risk).
In order to explain, let’s imagine that you’re considering buying stock in a given company.
Diversifiable risk is the risk resulting from the possibility that the company will fail–or at least, fail to earn a satisfactory level of profits.
Undiversifiable risk is the risk that results from the possibility that the stock market as a whole can decline in value over any given period of time.
The reason for the name diversifiable risk is that, if you own enough companies–that is, if you’re sufficiently diversified–then diversifiable risk is mostly eliminated. You’re no longer exposed to any significant risk resulting from the failure of one particular company.
In short, “diversifiable risk” = “risk that can be eliminated via diversification.”
On the other hand, no matter how many companies you own (except for “zero,” that is), you’re exposed to the possibility that the entire stock market will decline in value. Undiversifiable risk cannot be eliminated via diversification, hence the name.
Why the distinction matters
If you’ve done much reading about investing, you know that greater risk leads to greater expected return.
The reasoning is that, when an investment’s returns are volatile, it becomes less desirable to investors relative to investments with more predictable returns. This lower demand results in a lower market price for the investment, thereby resulting in a greater expected return.
Here’s the catch that many investors miss: When people talk about risk being rewarded with return, they’re only talking about nondiversifiable risk.
Why? Because if risk can be eliminated through something as simple as diversification, it’s not all that undesirable. As a result, it neither decreases demand nor increases expected return.
How you can profit with this knowledge
By understanding that the market only rewards risk that can’t be eliminated by diversification, you can set yourself up to maximize your expected return relative to your risk. How?
By diversifying like crazy. After selecting the asset classes in which you want to invest, diversify as broadly as possible within those investment classes. In other words, buy index funds.
Or to look at it from the opposite perspective: investing in individual securities within an investment class (ie, picking stocks) increases your risk without increasing your expected return. Sounds like a poor bet to me.
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{ 5 comments… read them below or add one }
I’m not currently in the market, but I really enjoyed this article. Uncompensated risk is something that I try to avoid in all area of my life. I think it is something that has gotten a lot of people in trouble over the last couple of years. Great read!
As 2008 clearly demonstrated, diversification, by itself, it simply not good enough. Owning index funds is better than mutual funds or picking a few stocks by yourself, but index funds also got pounded last year.
I don’t understand why the everyone – including the Oblivious Investor, doesn’t recognize the added value of hedging (reduce the risk of owning) a stock market portfolio.
The way to do that is to adopt simple, conservative option strategies.
Mark, how exactly did 2008 show that diversification isn’t good enough?
2008 showed big benefits of diversifying if you had some of your money in government bonds. Perhaps Mark is referring to the way other assets like property, commodity, commercial bonds and overseas equities all fell in sync though.
Mike,
You may want to have a follow up topic on diversification across asset classes.
Mark,
While diversification can’t protect against all loses- but it is still doing what it claimed to do.
To greatly simplify- diversification among asset classes can reduce risk by protecting against one market- like stocks falling. This strategy works because different asset classes don’t TEND to move together. However, you can’t diversify away the risk that all markets will go down at the same time which is what has just happened! Still diversification among stocks and bonds would have greatly reduced the % losses – for some evidence look at the following graph of some representative bond and stock EFT funds: VTI and BND over the last two years.
http://finance.yahoo.com/q/bc?t=2y&s=VTI&l=on&z=m&q=l&c=BND
From a visual analysis of the data they don’t look highly correlated to me
.
-Rick Francis