4-01 Risk, Reward, and Diversification

chapter4-1aRisk, reward, and diversificationA way of reducing the risk and variances in your portfolio returns by buying a variety of stocks across different industries, market caps, etc. are the most important concepts to understand before you start your portfolio. They are factors in all investment decisions. You must learn more than the textbook definitions of these factors–you need to understand how they, in conjunction with market timing and business cycles, affect your portfolio’s return. Even riskThe expected variance of the returns of your investments., when properly managed and understood, can often help your portfolio. There are different levels of risk and different types of diversification.

Simply put, “risk’ is the term used to determine the likelihood and volatility of your results. Risk typically goes hand-in-hand with returns: the more risk you take, the higher the return you would expect, and conversely, the lower risk you take, the lower the return you would expect.

The term “return” generally means profit, and in the finance/investing world is usually expressed as a percentage and is frequently annualized. Investing $100 and getting a $6 profit in 2 years has a return or profit percentage of 6% and an annual return of 3%. Investing $100 and making a $50 profit over 2 years has a 50% return and an annual return of 25%.

To understand risk and return, consider these 4 brothers (Adam, Bob, Charley and David) who have different ways to invest $100, and think about the “risk tolerance” of the each of them. Where do you fit?

  • Adam is extremely risk averse and puts the $100 in cash in a jar in his kitchen and sleeps very soundly at night knowing that he will always have $100 in the jar.
  • Bob is also risk averse, but he puts that same $100 in a money market account at the biggest and oldest bank in town. That money market accounts pays 1% and Bob is (almost) positive that in 12 months he will have $101 in that account.
  • Charley likes to take some risk and buys $100 worth of IBM stock. He researched the stock and discovered that over the last 10 years IBM’s annual return has varied between -10% and +57% so he is somewhat confident that his $100 will turn into an amount somewhere between $90 and $157.
  • David has a friend that’s a broker and his broker said that stock XYZ is in the bio-engineering industry and they ran a small test on a drug that seemed to cure cancer in 6 out of the 10 patients that tried it, and now they are in a test with 1,000 people. David’s broker says that if this second test has similar results, the stock will pop from $1 to $100 over the next year; but if it doesn’t go well, the company is out of cash and will likely have to fold. David buys $100 shares of XYZ hoping that the stock will at least triple, but he also knows that there is a greater chance the company will be bankrupt and he will lose his $100.

Obviously, these are 4 different personalities (think “risk-tolerances”) with 4 different expectations about their rewards. Since no one has a crystal ball to see the future, none of these 4 brothers knows what their final return will be in a year. Adam’s wife might mistakenly throw the jar away that has the $100 in it because she forgot he put it there; Bob’s bank could announce it is closing and money market funds were stolen by a malicious Ponzi scheme; Charley’s IBM stock could turn worthless if the company collapses Enron-style; and David’s bet on XYZ stock could be worth $10,000 or $0.

A primary investment goal is to minimize risk and diversification is the most reliable method of minimizing investment risk. Diversification is simply spreading risk around so that “all of your eggs are not in one basket.”

Now suppose the 4 brothers above had a 5th brother, Edward, who couldn’t make up his mind what to do with his $100 so he copied each of his brothers by investing $25 in each of their styles. This is a simple example of what diversification means.

Mathematically, diversification is about minimizing the variances in your returns by averaging the expected returns of each of your stocks. If Stock A had returns of -50% to +50% a year and Stock-B had returns of -10% to +10% a year, then it would make sense that a portfolio that was 50% invested in each of these two stocks would expect to have returns of -30% to +30%.

Now if we added Stock C which always has returned 5%, then a portfolio equally weighted with A, B, and C would have expected returns between -18% and +22%. But if I put 50% in C and 25% in each A and B, then we are at -13% to + 18%. Think of it like you are making a recipe for a spaghetti sauce. You know you will put in 3 ingredients, but if you like yours a little salty, you will go with more salt and less pepper.

This explains how we can average out our returns by buying different stocks, but the most important ingredient to diversify successfully is by buying stocks across different industries. As you might expect, you certainly DON’T want stocks in your portfolio that are all performing at their extreme worst at a single point in time. In other words, you want to choose stocks whose returns don’t correlate very strongly. If one stock is falling, you hope to have a few stocks that are rising to help offset the loss in the falling stock.

As we discussed in earlier chapters, understanding the business cycle and product life cycles helps to understand why some companies perform well at times that other companies are doing very poorly.

Mark's Tip
Diversifying across industries is not as difficult as it might seem, if you can take a step back and look at things from a very macro level. History is full of examples of some industries doing well while others are hurting. How do you think horse and buggy companies performed when Ford starting selling Model-Ts? How do you think vacuum tube companies did when hi-technology started moving towards the semi-conductor? How do defense stocks relate to medical stocks if the current U.S. President is expanding the budget for the military and asking cutting funding for Social Security benefits? Finally, don’t forget that sometimes investors don’t want to be in the market at all so they invest their cash in other investments like money markets, bonds, precious metals, etc. Remember, individual stocks and the stock market can move in 3 directions: Up, down, and sideways!

Now suppose we added stock D to our portfolio above which moves opposite to Stock A so that when Stock A is losing 50%, Stock D was gaining 20% and when Stock A was gaining 50% Stock D would lose 5%. Our equally weighted portfolio of A, B, C, and D would now have expected returns in the -9% to +15% range.

Here is a quick summary of some ways to accomplish diversification.

  • Across Stocks: It certainly helps to have more than one stock in your portfolio. College professors used to say that it took a minimum of 30 stocks to have a well-diversified portfolio. Lately, these academics are becoming more comfortable with a portfolio of only 10 stocks as long as they are very diversified.
  • Across industries: Investing in different industries spreads around the risk that any one industry could suffer a serious slump. For example, totally investing in oil, real estate, or auto manufacturers may generate wonderful returns in the short-term. However, a downturn in any one industry will wreak havoc with your portfolio overall.
  • Across market caps: Market capitalization, or “market cap” for short, is a way to identify and classify companies by the size of the total value of their public stock outstanding. Typically, stocks are classified as large-cap (greater than $10 billion market cap), mid-cap ($1-10 billion market cap), and small-cap (Less than $1 billion) companies. There are also newer classifications, like mega-cap (greater than $100 billion), micro-cap (Less than $100 million), and even nano-cap (less than $10 million). You can classify companies along these lines or with a different method of your creation. The key for you, as a newer investor, is to consider investing across different sized market caps to mitigate risk and increase the diversity of your portfolio.
  • Across dividend yields: Companies often differ widely in their approach to paying dividends. Some Boards of Directors strongly favor distributing earnings in the form of dividend payments, while others want to conserve cash to fund Research & Development (R&D) and/or growth. By investing in some securities with a track record of high dividend yields and also those that display cash conservation to fund new products or expansion, an individual gains some risk protection.
  • International and emerging markets: Economic globalization of the world overall has made emerging markets an excellent source of diversification. Emerging markets such as those in Brazil, Russia, India and China (the “BRIC” countries), are those countries that are quickly growing their national economies and tend to reflect a market-oriented philosophy. They typically seek direct investment at all levels of funding, including from the smaller investor. If you do your homework, you may find some wonderful opportunities to increase your portfolio and manage the risk factor, while enjoying good earnings and appreciation. International markets typically are riskier than mature markets in North America and Europe, but they also offer highly attractive returns.
  • Precious metals and commodity ETFs:

chapter4-1bMany people believe investing directly in precious metals (gold, silver, etc.) or through commodity ETFs (exchange traded funds), which are tied to precious metal indices, because these investments are valuable as diversification and risk mitigation tools. Once again, you should become familiar and comfortable with the historic movement of precious metals AND the global economic conditions that preceded or existed during these price movements. In addition, precious metals have “inherent” value along with market pricing.

  • Dollar Cost Averaging (buying and selling): Designed to reduce risk, dollar cost averaging strategies dictate that you buy smaller blocks of the same securities (versus large lump sum purchases) over time to reach the investment position you want. This often “smoothes out” the cost factor of these securities to help you manage the vagaries of market price changes – both up and down.

Mark's Tip
Don’t forget that you can dollar cost average when you sell, just like we taught you to dollar cost average when you are buying. When you’re not sure about a stock or stocks in your portfolio, don’t hesitate to sell 1/3 or ½ to start reducing your position over time. By spreading out your sales of a group of securities, you often “even out” the market price changes with dollar cost averaging to generate a more risk-free and stable return.