Posts Tagged "tandem"

What is "Diversification"? There is more to it than you might think!

Posted by Preet on Jul 31, 2007 | 0 comments

Diversification basically means not putting all your eggs in one basket. If you hold only one stock and that company went bankrupt, then you would have lost all your money.  If you hold two stocks and one company goes bankrupt you have only lost half your money.  And so on, and so on.

But there is a BIT more to it than just that. If you held two stocks in companies like Sprint and Verizon and someone invents a device that makes phones obsolete, then both companies might go under.  In this case you have diversified by holding two companies, but you picked two companies in the same industry!

Further, if you held two mutual funds that both invested in large Canadian companies (and each fund held 100 stocks), but the Canadian economy as a whole declined, both your funds would lose money.

So there is more to diversification than just holding more than one stock.  The key to proper diversification is to pick different stocks (or other investments) that are NOT CORRELATED to each other. i.e. the values of each do not move in tandem. So when one is up, the other is down, and vice versa. (You still want to pick only investments that are expected to appreciate long-term.)

There are many different way to diversify – something known as “Multi-Level Diversification”. You can diversify by:

1. Holding more than one stock

2. Holding investments from different sectors (Telecom vs Banks vs Mining, etc.)

3. Holding investments in different Asset Classes (Stocks, Bonds, Cash)

4. Holding investments in different Markets (Canada vs US vs China vs Europe, etc.)

…and that is just scratching the surface.

So the take home message is that proper diversification means holding numerous securities that are as uncorrelated to each other as possible, in order to reduce risk. Let’s say that ALL investments in the universe returned 7% over the next 100 years, BUT each had their own “cycle” of when it was up or down in the short term.  If you held only one, then perhaps it made a killing in the first 50 years, but got slaughtered in the second 50 years. And maybe a different one returned 14% one year and 0% the next, and continued to alternate for the next 98 years in a similar fashion, and so on. Imagine that there are 1000 different investments in this universe and each has a very unique pattern of returns, but ultimately returns 7% over the 100 years.  Well if you held them all, you would still get your 7% over 100 years BUT you had a MUCH SMOOTHER RIDE and the variance of any annual return from 7% would be minimal.  Risk is another word for variance – so to reduce variance is to reduce risk – which can be accomplished with proper diversification.

Please note that you can not entirely get rid of risk and that the examples given in this post (as always) are fictitious and intended for educational purposes only.

Risk: Systematic Risk vs Non-Systematic Risk

Posted by Preet on Jul 26, 2007 | 0 comments

This is an advanced level topic – you may want to skip this post if you are just finding your feet with respect to finances! It assumes a basic understanding of portfolio diversification…

With respect to any given stock market there are two types of risk (which is another word for variance according to Modern Portfolio Theory): 1) Systematic Risk and 2) Non-Systematic Risk. Systematic risk is the general ebb and flow of the market – kind of like the tendency for all stocks to get dragged down or move up in tandem at the same time to a certain degree.  For example, the 1987 market decline was a Systematic event in that it really didn’t matter what you owned, it probably went down.  Is it warranted? Yes and no, but a main thing to consider is that nothing probably happened to any one stock to make it lose value in and of itself that day, but rather there was a general expectation or fear of a downturn in the economy linked to the market that caused everything to move. SYSTEMATIC RISK CANNOT BE DIVERSIFIED AWAY.

Non-Systematic risk CAN be diversified away. The best way to describe it is to build an analogy. Let’s say you owned one stock – if that company went bankrupt you will have lost 100% of your portfolio. If you owned 100 stocks, and 1 comany went bankrupt you would have lost 1% of your portfolio. On the flip side, what if that one company doubled in value? You either doubled your money or only gained a measley 1% if you held 1 stock or 100, respectively.  So this analogy builds a case against diversifying too much, but making sure you diversify a little. Non-Systematic risk is like the individual risk associated with the company linked to the stock – if it goes bankrupt – that is non-systematic risk and has nothing to do with the general ebb and flow of the market overall.

So, I mentioned that non-sytematic risk can be diversified away. It is generally debated as to how many securities you need to hold to get rid of non-systematic risk. You see, just as one company might go bankrupt, one company in your portfolio might double in value.  And one company might increase by 25% and one might decrease by 25%. So most recent research papers tend to think that 15-20 securities is enough to get rid of non-systematic risk. They suggest that trying to diversify by adding more securities than that is pointless as you may be adding stocks that do not have as rosy a prospect as the initial 15 or 20.  They further argue that for those that over-diversify by having 100 securities from the same market have bought alot of garbage for the sake of diversifying and will not reap the same long term returns as someone who has been more picky with their money.

Since it is agreed that non-systematic risk can be diversified away, and systematic risk cannot – it is plain to see that the goal for a rational investor is to do just that.  So the debate is really how many securities do you need to eliminate non-systematic risk? For now, I would tend to agree that 15-20 is optimal within any given market to eliminate non-systematic risk.  Anything beyond that and you are buying ”filler” and reducing your long term rate of return – truly an irrational goal! :)