Diversification, market risks and stock specific risks.

 Section 11: Diversification, market risks and stock specific risks.

Elaboration of Section 11

This section delves deeper into the critical concept of diversification, explaining what it protects you from and, just as importantly, what it doesn't. It provides a practical framework for understanding and managing the two main types of risk in a stock portfolio.

1. The Two Types of Risk
The section begins by defining the components of total portfolio risk:

• Stock-Specific Risk (Unsystematic Risk): This is the danger that is unique to a single company or industry. Examples include:

  • A fraudulent accounting scandal.

  • A incompetent CEO making a poor strategic decision.

  • A competitor launching a superior product.

  • A factory fire or other operational disaster.

  • This risk is diversifiable.

• Market Risk (Systematic Risk): This is the danger that affects the entire market simultaneously. Examples include:

  • An economic recession.

  • Changes in interest rates by the central bank.

  • Inflation or deflation.

  • War or political instability.

  • A global pandemic.

  • This risk is non-diversifiable.

2. How Diversification Works
The section provides a clear, practical guideline for managing stock-specific risk:

• The "Magic Number" for Diversification: By holding 7 to 10 or more stocks in your portfolio, you can effectively diversify away most of the stock-specific risk. If one company fails due to a scandal, it will only be a small portion of your overall portfolio, not a catastrophic loss.

• The Limit of Diversification: The section makes a crucial point that many investors miss: there is no benefit to over-diversification. Holding 50, 100, or 500 stocks does not meaningfully reduce your risk further. In fact, it "attenuates the returns"—meaning your portfolio's performance will simply mirror the average return of the overall market. You give up the potential for superior returns by diluting your best ideas.

3. The Role of the Expert vs. The Defensive Investor
This leads to a key distinction in strategy:

• For the Enterprising Investor (The "Expert"): Someone like Warren Buffett, who is highly skilled at security analysis, does not believe in extreme diversification. For him, adding more stocks beyond his best 7-10 ideas would only "deworsify" his portfolio, diluting his top picks with inferior ones.

• For the Defensive Investor (The "Non-Expert"): For the vast majority of investors who lack the time, skill, or inclination to deeply analyze individual stocks, Buffett himself strongly advocates for low-cost index funds. An index fund that tracks the broad market (like the S&P 500) is the ultimate tool for diversification, allowing the defensive investor to achieve the market's return with minimal effort and cost.

4. Expanding Diversification: The Global Portfolio
The section introduces an advanced concept for further reducing risk: international diversification.

• By investing in the stock markets of other countries, you can reduce your exposure to the market risk of a single country (e.g., the risk of a political crisis or economic policy change specific to Malaysia).

• The example given is of South Africans during the apartheid era diversifying abroad to protect their wealth from country-specific political risk.

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Summary of Section 11

Section 11 explains that diversification is a powerful tool to eliminate stock-specific risk, but it cannot protect you from market-wide risk. The optimal level of diversification depends on whether you are an enterprising or defensive investor.

• Two Types of Risk:

  • Stock-Specific Risk: Can be eliminated by holding 7-10 or more different stocks.

  • Market Risk: Cannot be eliminated through diversification; it affects all stocks.

• The Diversification "Sweet Spot": Holding more than 10-15 stocks offers diminishing returns and simply turns your portfolio into a "closet index fund," guaranteeing you average market returns.

• Two Strategic Paths:

  1. Enterprising Investor: Concentrates a portfolio in their best 7-10 stock ideas.

  2. Defensive Investor: Uses a low-cost index fund to achieve instant and cost-effective diversification, accepting the market's average return.

• Advanced Tactic: Investing in international markets can help diversify away some country-specific market risk.

In essence, this section provides the "why" and "how" behind diversification. It teaches you to use diversification intelligently—not as a mindless mantra, but as a precise tool to manage the risks you can control, while acknowledging and preparing for the risks you cannot.

Risk in Stock Market – Stock Market Risk Management

Risk in the stock market is everywhere. Investing in the stock market is fraught with worry, for good reason. If you lose half of your investment, you must double your return to just breakeven. Warren Buffett, considered by many to be the world’s greatest investor, states his first rule of investing is “do not lose money.” Unfortunately, the risk in the stock market of losing your money is always a possibility. However, without taking some risk there is no reward. Therefore, successful investors employ stock market risk management strategies to minimize their losses. Managing risk in stock market starts with identifying the type of risk and taking action to mitigate the impact of the risk on your investment portfolio.

Risk in the stock market comes in many forms and each can lead to a loss. The most common is the overall trend of the market. Approximately 60 % of the move of an individual stock is attributed to the trend of the stock market. If the stock market is rising, it takes with it most of the other stocks, though not in equal amounts. When the stock market falls, stocks sink with it.

Another big risk in stock market lies with owning an individual stock. While owning the stock of a company can offer greater rewards, it also entails the risk that something might go wrong that can cut the price of the company’s shares in half. It might be news that sales have suddenly fallen due to a new competitor, or a product liability issue has arisen. For whatever the reason, individual stocks are subject to risk associated to them alone.

While there are other risks in the stock market, these encompass the vast majority of the ones you will encounter. Fortunately, investors can employ several strategies as a part of their stock market risk management program.

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Responding to risks: Concentrating risks

Concentrating risks is the opposite of diversifying - it means deliberately 'putting all your eggs in one basket'.  The effect is opposite too:  it increases the severity of potential impacts, but reduces management overheads, variables, unknown factors and dependencies.

An example of concentrating risk would be assigning a single person to a project full time, rather than assigning a small team part time. 
The time and cost of running the project might well be reduced, and the project might well be reduced, and the project may be run in a more coherent way, but there is a risk that the key individual will move on, damaging the chances of delivery.

The equivalent in financial terms is investing heavily in one or two stocks or products that you believe are sound, rather than spreading risk around because you are less sure of your market knowledge.

Concentrating risk depends for its success on the skill and knowledge of decision makers.  With fewer chances to correct mistakes, people need to get it right first time.