Investors have an important choice to make when deciding on the size and number of investments to hold in their portfolio. On the one hand, investors can lower the risk of their portfolio through diversification. On the other, transaction costs increase with the number of stocks purchased.
In this article, we're going to discuss the topic of portfolio risk and diversification. We're going to start that discussion with a brief overview of the risks contained within a portfolio of stocks. Next, we'll talk about diversification, and how this concept is different from hedging. Finally, we'll talk about an approach that can be used to minimize risk by using an optimal diversification approach.
What is Portfolio Risk?
Portfolio risk refers to the possibility of the combination of assets held within a portfolio failing to meet financial objectives. Each asset held in a portfolio carries its own risk. Securities with higher upside potential typically bring about higher risk.
Diversification within and among asset classes, help mitigate the risk by making sure that the success of your portfolio doesn’t depend on a single security or a set of securities that depend on the same circumstances to turn a profit.
It should be noted that while diversification is a viable approach for portfolio risk, it merely minimizes it – doesn’t eliminate it completely.
The Capital Asset Pricing Model tells us there are two forms of risk to which all portfolios are exposed:
Systematic Risk: also known as beta and market risk, this is a macro-level threat. For example, a recession could depress the performance of the entire stock market. Systematic risk is evident when a diverse set of stocks, such as the S&P 500 Index, experience a decline. Hedging is the only means of mitigating this problem.
Individual Stock Risk: also known as unsystematic, idiosyncratic, and diversifiable risk, this is security-specific. For example, a company could make a poor business decision that leads to a lowering of its stock price. In this scenario, the stock market may continue to rise, but this particular stock's price would fall. Holding a diversified portfolio of stocks can mitigate this type of risk.
Understanding Diversification
As we said before, portfolio diversification is the practice of spreading investments to limit the risk exposure to any one type of asset. In essence, this strategy helps to mitigate market volatility in the long haul.
There are many different ways of combining assets, most within asset classes, among different asset classes, and among geographies.
Among Industries & Sectors
Sectors and industries operate in very different ways from one another and are typically driven by a variety of factors. During the COVID-19 pandemic, for example, the travel and leisure industry took a great hit as the restrictions brought the global travel industry to a halt.
While this was happening, we’ve witnessed industries such as e-commerce or digital streaming thriving due to the same circumstances. By distributing funds across varying industries, investors can effectively diversify away the unsystematic, sector-specific risks.
Among Different Asset Classes
Each asset class, namely stocks, bonds, or commodities, has its own unique set of risks and benefits. As we said before, higher-risk securities usually come with a potential for higher returns, and vice versa.
Investors usually seek balanced asset allocation models among different asset classes based on risk tolerance and investment goals. Here’s a comparison of the most common asset classes:
Definition | Average Returns | Risk Exposure | |
|---|---|---|---|
Stocks | Shares in a publicly traded company | 8-10% | High |
Mutual funds | Collection of securities, managed by professional managers | 4-10% | Medium to high |
Exchange Traded Funds (ETFs) | Basket of securities that follow an index, commodity, or industry | 4-10% | Medium to high |
Bonds | Debt instruments issued by corporations or governments as fixed-income securities, help generate regular income | 5-6% | medium |
Cash and short-term cash equivalents (CCE) | Short-term, low-risk investments such as treasury bills or CDs | 1-3% | Low |
Among Geographies
Much like asset classes, countries and regions are typically driven by varying economic conditions. By investing in foreign securities, investors can dissipate their reliance on one country or economic region to thrive, and offset their risk exposure at times of economic downturn.
Besides mitigating risks, foreign markets may also come with greater upside potential – but also a higher degree of risk. This is particularly true when diversifying across emerging and developing markets, such as China, India, Brazil, or South Africa.
Diversification vs Hedging
Portfolio risk can be lowered by utilizing two related, but different, techniques. Systematic risk can be reduced through hedging, while individual stock risk can be reduced through diversification. The difference between the two concepts is subtle, but worthwhile reviewing:
Diversification: generally, as the number of assets in a portfolio increases, the risk of the portfolio decreases. Diversification relies on a loose relationship between the returns of the assets in the portfolio. For example, among a group of ten stocks, one company might make a poor business decision, which results in a decrease in that stock's price. However, the return on investment for the remaining nine companies were unaffected by this decision.
Hedging: when two assets are negatively correlated, they can be held together in a portfolio to reduce systematic risk. For example, during an economic recession, the prices of stocks will be depressed. Fortunately, the price of gold typically rises during a recession. This negative correlation means that gold can be held as a hedge against inflation.
Note: Make sure to read about our guide to inflation and its effects to get your investments steeled against depreciation.
To summarize, the concept of diversification applies to similar assets with uncorrelated returns. The concept of hedging applies to dissimilar assets with returns that are negatively correlated.
An investor can lower risk through diversification when they take an existing investment and spread the dollars over a larger number of stocks. For example, an investor holding $500,000 in Alphabet stock can mitigate individual stock risk by selling $450,000 of their Alphabet stock and purchasing $50,000 in the stock of nine other companies. In this example, the size of the portfolio did not increase, it remained at $500,000.
If that same investor purchased $50,000 in the stock of nine other companies, without selling their Alphabet shares, they have increased the total dollars at risk.
Even though they own shares of stock in ten companies, they now have $950,000 invested in the market. They didn't decrease the risk associated with Alphabet stock. Instead, they added additional risk by purchasing shares in nine other companies too.
This is an important point. By increasing the total money invested in the stock market, the overall risk of the new portfolio increased.
On the other hand, hedging allows the investor to increase the size of their portfolio (in terms of dollars) and reduce their overall risk. This occurs because the return on the new investment increases when the existing investment declines.
The Effects of Diversification on Risk
We've talked about how risky it is to hold a single stock, and how that risk is related to an unexpected event. The example given earlier was a poor business decision that might hurt profits. The forecasted, or actual, profits for this company varied from the market's original assumption. Mathematically, we could describe this risk as a variance.
In October 1977, The Journal of Business published Risk Reduction and Portfolio Size: An Analytical Solution. Written by Edwin J. Elton and Martin J. Gruber, this study examined the mathematical formulas needed to determine the effect of diversification on risk. On a more practical level, Elton and Gruber also examined a portfolio of 3,290 securities and calculated the variability in returns versus the number of stocks held in a portfolio.
The table below is based on information appearing in that 1977 publication.
Stocks in Portfolio vs Risk
Stocks | Variance | Risk Reduced |
|---|---|---|
1 | 46.811 | |
2 | 26.934 | 24.1% |
4 | 16.996 | 39.7% |
6 | 13.683 | 45.9% |
8 | 12.027 | 49.3% |
10 | 11.033 | 51.5% |
20 | 9.045 | 56.0% |
50 | 7.853 | 59.0% |
100 | 7.455 | 60.1% |
200 | 7.256 | 60.6% |
500 | 7.137 | 61.0% |
1000 | 7.097 | 61.1% |
The above information is interpreted in this manner. The first column of data shows the number of stocks held in the portfolio. The variance data represents the actual variance found by Elton and Gruber for each portfolio. The last column of data demonstrates how much risk is reduced versus holding a portfolio consisting of a single stock. For example, by holding ten securities in a portfolio versus a single stock, an investor can lower the variability of their portfolio's return by 51.5%.
Generally, the conclusion from this study is that diversification beyond 30 securities will not result in a significant reduction in diversifiable risk. From a practical standpoint, a portfolio consisting of at least 10 stocks will contain less than half the risk of owning the stock of just one company.
FAQ
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