This article was originally published in River Hill Magazine.
The fastest way to accumulate wealth is to buy the stock of the best company you can find, invest all of your available cash, and sit tight until you eventually need the money. Most people do not follow this approach because they realize no one is able to predict the future with any degree of certainty, and they are uncomfortable with the investment risk. This concentrated strategy can be the fastest way to lose all of your wealth if you place a bad bet.
It is possible to reduce overall portfolio risk and volatility by creating a diversified portfolio. From the chart below, total investment risk can be divided into unsystematic risk and systematic risk.
A truly diversified portfolio eliminates unsystematic risk. The first component of unsystematic risk is business risk. Business risk is risk that is attributed to a particular industry, competitive threats, and regulatory constraints. The second component of unsystematic risk is financial risk. Financial risk is related to the financial health of the company itself, its level of debt, its cash flow, earnings, and profits.
When you purchase the stock or bond of a single company, unsystematic risk is an additional risk that you incur. The professional investment community generally agrees that a basket of at least 25 – 30 different stocks must be held in order to minimize or perhaps virtually eliminate unsystematic risk from a portfolio. Keep in mind, however, that risk and volatility is the investor’s friend in a rising bull market. Some investors are perfectly willing to take on higher risk with the hope of achieving higher returns. A diversified portfolio will generally not lead to the highest returns over time, but should offer more stable and consistent returns than a portfolio that is not adequately diversified.
The second major category for investment risk is systematic risk. The four types of systematic risk are purchasing power risk, interest rate risk, market risk, and exchange rate risk. Purchasing power risk refers to the risk of inflation. Stocks have proven to be a good long-term hedge against inflation. It is prudent therefore for most investors to have at least some portion of stocks or stock funds in their portfolio. Interest rate risk refers to changes in market interest rates. When interest rates rise, bonds lose market value, and stocks quite often perform poorly as well.
Market risk is related to the behavior of the market in general. In the long-run, the stock market is driven primarily by the growth of earnings. In the short-run, the market can be driven by irrational and emotional factors. Many individual investors do not realize how much the performance of a company’s stock is dependent with the behavior of the general market. The statistical term for this is beta. The best way to diversify against market risk is to hold different asset classes in your portfolio that behave differently (not highly correlated). This strategy involves using a combination of cash, bonds, stocks and even other asset classes. Within the major category of stocks, an investor can further diversify by choosing among small, large, growth, and value stocks.
The last type of systematic risk is exchange rate risk. Exchange rate risk results from adding international investments to a portfolio. It is impossible to eliminate systematic risk completely from a portfolio, but it can be reduced.
If your investment goal is to implement a strategy of lower volatility and reduce risk, then avoiding individual stocks in favor of using more broadly diversified funds should provide a smoother ride.
Christopher P. Parr CFPTM is a River Hill resident and President of Parr Financial Solutions Inc.- an independent, fee-only financial advisory firm: www.ParrFinancialSolutions.com