The Dangers of Owning Individual Stocks - Part 2

Today is Part 2 in our series - The Dangers of Owning Individual Stocks.

Last week discussed the importance of investors realizing that the media has a business model that relies on selling ads and getting readers. Their goal is to create the highest volume of readers possible. The headlines will be written in a manner that attracts attention and drives intense emotion. The non-stop barrage of headlines is dictated by the current economic conditions which in turn impacts market cycles. Investors can run the risk of becoming fearful and succumb to behavior that could potentially hurt their portfolio and take unnecessary risk by reacting.

We also discussed the importance of formulating an investment philosophy. For many investors, an investment philosophy may be unusual since they may have never thought about it before or pondered the question. An investment philosophy will dictate how an investor implements a portfolio strategy.

Lastly, we offered a simple challenge to be on the lookout for financial media headlines. Our hope was that you could see how the headlines are designed to drive fear and uncertainty.

Today we will discuss the specific dimensions of risk and the importance of diversification in a portfolio. The word risk gets tossed around a lot and it is important to have a concise definition of what it means when it comes to investing, particularly individual stock investing.

The consideration of risk and return

Involved in everyone's investment decisions is the consideration of risk and return. As illustrated in the various headlines from last week's article, it is evident that investment decisions are often made from some sensational headline, prognostication of fund managers or the bullish outlook from a company CEO touting their stock.

As an investor, what you are generally seeking is a future return for your hard earned dollars. The idea that you can compound your dollars is enticing plus a return will help with the constant rise in inflation!

The problem that investors face is that the financial industry and media focus so heavily on one aspect of investing...RETURNS! Why do they do this? Because focusing on RETURNS sells products. Of course, returns are always touted in a positive light. Conversely, you do not hear as much about RISK. Why? Risk is seen as negative because it talks about potential loss. Who wants to talk about losing since we all love winners!

However, risk is just as important as returns because they are linked--you cannot have returns without taking risk. This is not a new concept but often gets missed in times of bull markets when it seems that everything is a winner.

1990 Nobel Prize Winner Harry Markowitz articulated this when he wrote his famous article titled Portfolio Selection in 1952. Markowitz presented a theory of risk and return called Modern Portfolio Theory (MPT). Modern Portfolio Theory states that: "any given investment's risk and return characteristics should not be viewed alone but should be evaluated by how it affects the overall portfolio's risk and return. That is, an investor can construct a portfolio of multiple assets that will result in greater returns without a higher level of risk." (Investopedia)

Let's Talk About the Different Types of Risk

What are the different types of risk? And, as an investor, is there a difference between individual stock risk versus the risk of investing in a basket of stocks (like mutual funds or ETFs)?

First and foremost, investing in the market is an amazing tool for wealth creation. However, it can be a very risky endeavor if one does not weigh good and bad risk.

Risk is the possibility that an investment will not perform as expected. The investment industry and investment experts generally use standard deviation to measure an investment's risk. Standard deviation is a measure of how much a security's price fluctuates compared to the average price for that security. It is a way to determine how much the price has moved up or down from its average value. The higher the standard deviation, the more volatile the price is.The higher the standard deviation, the more wild your investment will be—in good times and bad. The lower your standard deviation, however, the less volatile your investment will be—its price will not vary as much from its average value.

What is important for investors to come to grip with is the difference between risk and uncertainty. They're not the same thing. Risk is simply the chance of something bad happening. Uncertainty is not knowing what will happen.

Understanding different types of risk

If you were to pick up a college level finance book, you will see a number of types of risk usually listed: business risk (risk that affects that particular company), market risk (risk that impacts the overall market), industry risk (risk impacting a particular industry), interest rate risk (like today's mortgage market), default risk (usually associated with bonds), and inflation risk. There are others as well.

Every investment decision that you make is a risk and will always have to be weighed against the risk of expected return. In general, financial theory classifies investment risks affecting asset values into two categories: systematic risk and unsystematic risk. Investors are exposed to both of these types of risks.

Systematic risks

This risk is how stocks are impacted by factors like interest rates and inflation. Systematic risk is the type of market risks that can affect an entire economy or a large percentage of the economy overall such as changes in interest rates or inflation, foreign exchange fluctuations, currency fluctuations, market liquidity, and the business environment of the country.

Unsystematic risks

Unsystematic risk is often referred to as company specific risk since it consists in the business and financial risk of a particular company or its industry. When it comes to your portfolio, this type of risk can be mitigated through diversification.

Market Risk

Market risk the possibility that all stocks in a particular category or segment of the market will decline at once because of factors like recessions or economic downturns. For example, when the dot-com bubble burst in 2000, many investors lost money because their stock holdings were not diversified across asset classes or other markets but narrowly invested in tech stocks.

Risk and the Benefits of Diversification

The word diversification is overused and can lose its meaning when it comes to your portfolio. Many investors think diversification is owning a bunch of individual stocks, especially the stocks that are having a meteoric climb.

Good and Bad Risk

There are good risks and bad risks when it comes to investing and building your portfolio.

What is considered good investment risk? Good investment risk is risk worth taking since you are being compensated for it. This type of risk cannot be diversified but investors are rewarded for taking it since there is a higher expected return premium compared to something safe like bonds or cash. If investors were not rewarded for this risk, no one would invest in the market. On the flip side, bad risk is uncompensated risk since the investor is not rewarded for it.

All investors face this sort of risk when they invest in the stock market. For example, there is a market premium for investing in stock and stock mutual funds. This is often referred to as the equity premium. Within the market, there are varying levels of risk depending on the type of stock it is. For example, large company stocks are less risky than small company stocks but you will sometimes earn a premium for investing in the riskier asset of small company stocks vs. large company stocks. You cannot diversify this risk away because there is a premium of small stocks over large stocks.

The Risk of Individual Stocks

There is risk associated with owning individual company stocks. In a study from 2001 in the Journal of Finance (Malkiel, Campbell, Lettau and XU) called "Have Individual Stocks Become More Volatile?" found that individual stocks were significantly more volatile, when compared to the volatility of the overall market. Their findings were that individual stock carried much more risk volatility when compared to a diversified portfolio.

Individual Stocks risk can be diversified away when investing in an asset class fund that contains all the stocks in an entire asset class or index rather than the individual stock itself. The reason that individual stock is so risky is that market risk can be considered temporary (there has never been a permanent loss in the total stock market). However, there can be permanent loss in an individual stock since many individual companies go to zero.

As Larry Swedroe writes, "Because the risk of single-stock ownership can be diversified away, the market doesn’t compensate investors for assuming this type of (unsystematic) risk. And because the risk can be diversified away without lowering expected returns, why so many investors hold concentrated portfolios remains a puzzle."

Conclusion

There are good risks and bad risks when it comes to investing and building your portfolio. The challenge for any investor is to understand how they are compensated for the risk they are taking. To focus solely on return can be problematic since the portfolio may be exposed to risk that is unnecessary and uncompensated. To learn more about how you can be better diversified in your portfolio strategy, contact us.