Non-Market Risk and a Concentrated Portfolio

Holding a concentrated portfolio is not as risky as one may think.

Just holding 2 stocks instead of 1, eliminates 46% of your unsystemic risk.

Holding only 8 stocks will eliminate about 81% of your diversifiable risk.


What about the range of returns?

Average return of the stock market during one period examined was about 10%.

Statistically, the one-year range of returns for a market portfolio (holding scores of stocks) in this period was between -8% and +28% about two-thirds of the time.  One-third of the time, the returns fell outside this 36-point range.

If your portfolio is limited to only 5 stocks, the expected return remains 10%, but your one-year range expands to between -11% and +31% about two-thirds of the time.

If there are 8 stocks, the range is between -10% and +30%.


Conclusion

It takes fewer stocks to diversify a portfolio than one might intuitively think.

ALL EQUITY SECURITY INVESTMENTS PRESENT A RISK OF LOSS OF CAPITAL

Investment performance is not guaranteed and future returns may differ from past returns. As investment conditions change over time, past returns should not be used to predict future returns. The results of your investing will be affected by a number of factors, including the performance of the investment markets in which you invest.

The Sources of Risk in Stock Investing

Total Risk = Unsystematic Risk + Systematic Risk

Unsystematic Risk (diversifiable)
Business Risk
Financial Risk

Systematic Risk (nondiversifiable)
Market Risk
Interest Rate Risk
Reinvestment Rate Risk
Purchasing Power Risk
Exchange Rate Risk

The Sources of Risk in Stock Investing

Total Risk = Unsystematic Risk + Systematic Risk

Unsystematic Risk (diversifiable)
Business Risk
Financial Risk

Systematic Risk (nondiversifiable)
Market Risk
Interest Rate Risk
Reinvestment Rate Risk
Purchasing Power Risk
Exchange Rate Risk

Market Risk

Which statement(s) is/are FALSE about market risk?

I. It is mitigated by writing calls.

II. It includes the risk the investor will lose invested principal.

III. It is the same as systemic risk.

IV. It is mitigated by buying defensive stocks.


A. I only

B. II only

C. II and III

D. III and IV





Correct answer: B

Statement II describes capital risk not market risk.


http://www.investopedia.com/ask/answers/09/series7-070709.asp?partner=pitm12a

Market risk or systemic risk

This risk cannot be eliminated by diversifying one's portfolio.

Definitions of Market risk on the Web:

Market risk is the risk that the value of an investment will decrease due to moves in market factors. The four standard market risk factors are: * Equity risk, the risk that stock prices will change. * Interest rate risk, the risk that interest rates will change. ...en.wikipedia.org/wiki/Market_risk

The possibility that the value of an investment will fall because of a general decline in the financial markets.www.waddell.com/jsp/index.jsp

The chance that a security's value will decline. With fixed income securities, market risk is closely tied to interest rate risk--as interest rates rise, prices decline and vice versa.www.netxclientdemo.com/invest_glosry_MMa.htm

Exposure to changes in market prices.www.info-forex.com/glossary.htm

Also called systematic risk. The portion of a security’s risk common to all securities in the same asset class, and that cannot be eliminated through diversification.www.manealfinancial.com/Glossary-MtoZ.htm

One of six risks defined by the Federal Reserve. The risk of an increase or decrease in the market value/price of a financial instrument. Market values for debt instruments are affected by actual and anticipated changes in prevailing interest rates. ...www.americanbanker.com/glossary.html

Exposure to a change in the value of some market variable, such as interest rates or foreign exchange rates, equity, or commodity prices.www.fhlb.com/Glossary.html

Market risk refers to the risk of financial loss as a result of adverse market movements. NZDMO specifically measures market risk with regard to movements in interest rates and foreign exchange rates.www.oag.govt.nz/2007/nzdmo/glossary.htm

The value of a security may decline due to general market conditions that are not specifically related to a particular company, such as real or perceived adverse economic conditions, changes in the outlook for corporate earnings, changes in interest or currency rates or adverse investor ...www.dreyfus.com/content/dr/control

Uncertainty in the value of real estate due to market, economic, political or other conditions.www.new-york-new-york-real-estate.com/m2.html

The risk of loss resulting from changes in the prices of financial instruments in the markets in which Chase participates, such as changes in the value of foreign exchange or fixed-income securities.https://www.chase.com/inside/financial/annual/glossary.html

Risk that cannot be diversified away. Related: systematic riskbiz.yahoo.com/glossary/bfglosm.html

Risk relating to the market in general and cannot be diversified away by hedging or holding a variety of securities.charmforex.com/index.php

Risk of loss due to unfavourable price changes on the financial markets.www.ingwholesalebanking.com/smartsite.shtml

risk that comes from customers not wanting to buy a product, the market being smaller than originally estimated, or a competitor launching a competing product. http://www.google.com/url?&q=http://www.epilepsy.com/innovation/entrepreneurs/glossary&ei=FexiSvKmMZWBkQWf1antDw&sa=X&oi=define&ct=&cd=1&usg=AFQjCNFChX-S8PEUc0fWkKKMwHxGc_shwA

Is now the time to bail out?

Is now the time to bail out?
A volatile market isn't necessarily a bad market. But selling when stocks are down is usually a bad idea.

By the Mole, Money Magazine's undercover financial planner

October 29, 2008: 5:47 AM ET

NEW YORK (Money) -- Question: I know market timing is a loser's game. However, I do think there is abundant evidence that the next 12-18 months are going to be very difficult for equities. Do you see any merit in trimming some equity holdings, parking the proceeds in short-term bonds or cash, and committing to immediately dollar-cost averaging back into the market on a monthly fixed schedule?

The Mole's Answer: Your question is a very sophisticated way of asking whether you should bail from the market right now. While I don't know your total situation, I can tell you that selling after equities are down by 40% is usually a bad thing.

First of all, I wholeheartedly agree with your statement that market timing is a loser's game. Many studies have shown the systematically bad job that individual investors do of timing the market.

We are constantly testing the market winds. When conditions are favorable, we increase our exposure. When conditions become so far from favorable that they're in another zip code, such as what we're currently experiencing, we decrease our exposure.

Unfortunately, we tend to do both of these things after the fact. Truth be told, we all want stock returns during bull markets and money market returns in bear markets. But as much as we may want them, no one really knows exactly how to get them, since we can't predict when bear markets and bull markets are beginning or ending.

Second, when you state that the next 12-18 months are likely to be "difficult" for equities, I'm not sure I agree with you. If by "difficult," you mean volatile, then you are probably right.

The last few weeks in the stock market has set all sorts of records for volatility. Emotions are running wild and there is a likelihood that this volatility will not end anytime soon.

But I would not agree that this translates into a bad period for the stock market. Primarily because the stock market is a better buy today than it was last year. In fact, I can quantify it by saying it's a 40% better value.

Which begs the question, why wasn't I getting as many inquiries about selling last year when the market was hitting new highs?

But that's a rhetorical question - the answer is that we humans have a tendency to predict the future based on the recent past.

This "recency bias," as it's known in the financial planning world, has us thinking inside the box of current events. If the market is thriving, as it was between 2003 and 2007, then we believe it will always be thriving. And in times like these when the sustained market dive is giving us all nose bleeds, we believe we'll never pull out of it.

Onto your question of whether you should sell now with a commitment to buy back in with periodic purchases, also known as dollar-cost averaging. As sophisticated and well thought out as this sounds, it still means selling your equities after they are down by 40%, and still equals market timing.

A better time to consider selling would have been last year after equities had more than doubled.

I can't tell you how the stock market will perform over the next 12 -18 months. No one can. It may very well turn out to be the right thing to do but the odds are very much against you.

Studies actually quantify that we pay an average penalty of 1.5% annually for timing the stock market and chasing the hot performers. Many of us come up with all sorts of rationale for doing what we're doing, but it ultimately just results in outsmarting ourselves.

The fact that you say you will commit to buying back periodically is a bit confusing. I'm glad you realize the market doesn't signal to us that we have hit bottom and that now is the time to buy, but it also hasn't sent you a signal that now is the time to sell.

Systematic rebalancing would have had you selling some of your stocks between 2002 and 2007, as they were skyrocketing. Now is probably when you should be buying.

My advice: Find an asset allocation that is right for you and stick to it. Try to rebalance in times like these, which actually means buying more stocks. Remember that investing during a rough economy can be the right thing to do. If someone tells you that you can have the upside of the market without the risk, don't believe them.

The Mole is a certified financial planner and certified public accountant who - in the interest of fairness - thinks you should know what goes on behind the scenes in financial planning. Want to make contact? E-mail him at http://money.cnn.com/2008/10/28/pf/Ask_the_mole.moneymag/mailto:themole@moneymail.com. Send feedback to Money Magazine



Find this article at: http://money.cnn.com/2008/10/28/pf/Ask_the_mole.moneymag/index.htm

Types of Risk (Total risk = Unique risk + Market risk)

Modern portfolio theory looks at risk from a different perspective. It divides total risk as follows:

Total risk = Unique risk + Market risk

Unique risk (Diversifiable risk or Unsystematic risk)

The unique risk of security represents that portion of its total risk which stems from firm-specific factors like

• the development of a new product,
• a labour strike, or
• the emergence of a new competitor.

Events of this nature primarily affect the specific firm and not all firms in general.

Hence, the unique risk of a stock can be washed away by combining it with other stocks. In a diversified portfolio, unique risks of different stocks tend to cancel each other - a favourable development in one firm may offset an adverse happening in another and vice versa.

Hence, unique risk is also referred to as diversifiable risk or unsystematic risk.

Market risk (Non-diversifiable risk or Systematic risk)

The market risk of a stock represents that portion of its risk which is attributable to economy-wide factors like

• the growth rate of GDP,
• the level of government spending,
• money supply,
• interest rate structure, and
• inflation rate.

Since these factors affect all firms to a greateror lesser degree, investors cannot avoid the risk arising from them, however diversified their portfolios may be.

Hence, it is also referred to as systematic (as it affects all securities) or non-diversifiable risk.

Market Risk

Even if the earning power of the corporate sector and the interest rate structure remain more or less unchanged, prices of securities, equity shares in particular, tend to fluctuate.

While there can be several reasons for this fluctuation, a major cause appears to be the changing psychology of the investors.

There are periods when the investors become bullish and their investment horizons lengthen. Investor optimism, which may border on euphoria, during such periods drives share prices to great heights. The buoyancy created in the wake of this development is pervasive, affecting almost all the shares.

On the other hand, when a wave of pessimism (which often is an exaggerated response to some unfavourable political or economic development) sweeps the market, investors turn bearish and myopic. Prices of almost all equity shares regiter decline as fear and uncertainty pervade the market.

The market tends to move in cycles. As John Train says:

"You need to get deeply into your bones the sense that any market, and certainly the stock market, moves in cycles, so that you will infallibly get wonderful bargains every few years, and have a chance to sell again at ridiculously high prices a few years later."

The cycles are caused by mass psychology. As John Train explains:

"The ebb and flow of mass emotion is quite regular: Panic is followed by relief, and relief by optimism; then comes enthusiasm, then euphoria and rapture, then the bubble bursts, and public feeling slides off again into concern, desperation, and finally a new panic."

One would expect large scale participation of institutions to dampen the price fluctuations in the market. After all institutional investors have core professional expertise to do fundamental analysis and greater financial resources to act on fundamental analysis. However, nothing of ths kind has happened.

On the contrary, price fluctuations seem to have become wider after the arrival of institutional investors in larger numbers.

Why? Perhaps the institutions and their analysts have not displayed more prudence and rationality than the general investing public and have succumbed in equal measure to the temptation to speculate.

As John Maynard Keynes had argued, factors that contribute to the volatility of the market are not likely to diminish when expert professionals supposedly possessing better judgment and knowledge compete in the market place.

Why? According to Keynes, even these peope are concerned with speculation (the activity of forecasting the psychology of the market) and not enterprise (the activity of forecasting the prospective yield of assets over their whole life).