A Tool to Manage Specific Risk

The common stock of a single business is loaded with risk. It not only bears the systemic risk of the stock market as a whole, but it also carries all the various business risks that can possibly affect the company it represents.

What Do These Stocks Have In Common?
		Avon		Walt Disney
		Chrysler		Holliday Inns
		Clorox		Polaroid
		Western Union		Zenith
They have all declined more than 70%

Diversification is a management tool designed to reduce the risk of holding individual stocks. Diversification simply means ‘spreading the risk’. If I purchase shares in only one company, my risk is high, because that company could fail and I could loose my entire investment. However, if I buy a cross section of stocks from different industries, the chances of all of them failing are almost zero. By diversifying my holdings, I have marginalized the specific risk.

Instead of holding 10,000 shares of a niche drug company, I hold 1,000 shares each of companies in: retail, communications, software, chip manufacturer, banking, insurance, fast food, automotive, appliances and drugs. Diversification will definitely lower specific risk. Diversification provides safety from specific risk, but comes with a cost, because it also lowers your potential profit.

Anyone can get lucky and select a stock that rises 200% or even a 1000%. If this is the only stock in their portfolio, they are indeed a happy investor. The chances of picking an individual stellar stock are extremely low. Well over one in a thousand. However, some people do it and the more research you do, the better your chances of picking a winner.

Unfortunately, the chance of picking two or three such stocks is astronomical. You have much better odds with the lottery. Therefore, the mere act of diversification reduces your chance of beating the market. The more stocks that are used to diversify a portfolio, the closer the portfolio tracks the overall market. This is one of the reasons that mutual fund managers, even though very experienced and well schooled, have trouble consistently outperforming the market.
Beta

No matter how financially solid an individual company or how innovative its management team, it can not escape its financial surroundings. It is still anchored to the economy and still subject to the whims of investor sentiment. Beta is a statistic that investment managers use to measure how closely the price performance of an individual stock, or a portfolio of stocks, are tied to the overall market.

A beta of one means that a specific stock is perfectly correlated with the market. When the market goes up or down 10%, the stock can be expected to follow and move up or down 10%. A beta of two means the stock or portfolio is twice as volatile as the overall market and when the market goes up or down 10% the stock can be expected to react by moving up or down approximately 20%. Stocks with betas of less than one are less volatile than the market as a whole and a negative beta means that the stock moves somewhat opposite to the market. A beta of zero means a stock has no relationship to the overall market and its price fluctuations will be entirely independent of the market. There are no zero beta stocks in the US.

It must be stressed that a beta is a statistical measure, not a crystal ball. Statistics work on averages - the most common outcome. But the real world is made up of anomalies. Sometimes statistics are perfect predictors and other times they are not even a close guess. Statistics indicate the probably of an action and are only predictive over a large number of instances. For example a stock with a beta of 1.5 can be expected to rise and fall one and half times faster than the general market. However, on any given day, it may react very differently and appear to be entirely independent of the market. It is only when we compare its price performance to the market over several years that we see the 1.5 beta pattern.

Managed Portfolios

A popular method of diversification is through a managed portfolio. A managed portfolio is a group of stocks that are selected, and continuously managed, by an investment professional. Mutual funds are a common example of managed portfolios. Exchange traded funds (ETFs) are another example. An ETF is a publicly traded portfolio that has an investment objective to mimic the price actions of a specified stock market index, such as the Dow Jones Industrials, the S&P 500, the NASDQ 100, the Russell 2000 or some other index.

Investment managers use betas to compile a stock portfolio that will presumably respond to the stock market in a predictable fashion. The more stocks in a portfolio, the greater the chance that the betas will be a reliable predictor of the portfolio’s price actions. Think of a beta as an invisible string binding a company to its fellow businesses. An individual stock may fly away from the group and do its own thing. However, a portfolio contains a collection of stocks and that means a bunch of strings. It is impossible for the group to break very far away from the whole and operate independently. A portfolio of stocks will always be heavily dependent on the price action of the overall stock market.

Managed portfolios are common in 401k plans and other kinds of employee benefit plans. They also provide the main funding mechanism for variable annuities and variable life insurance policies. Often the managed portfolio selections available inside 401k’s, variable annuities and variable life insurance policies are clones of publicly available mutual funds. A clone fund is a stock portfolio that is managed in such a way as to provide essentially the same investment results as a larger more publicly available mutual fund. A clone fund is not always exactly identical to its parent counterpart, but the financial result over a few years should be similar.

All managed portfolios have a stated investment objective. If you select a managed portfolio of any type, please make sure your financial objective match those of the funds management.

Alpha

An alpha is just the opposite of a beta. It is the amount of price chance not related to the overall stock market. The alpha statistic measures the degree of freedom in an individual stock or a group of stocks. The extent to which a given stock deviates from its beta and performs better or worse that its beta prediction, is due to the performance of the company itself. Alpha is a measure of how well management has handled the specific risks facing the company. A high alpha for an individual business indicates the presence of an excellent management team and one that is squeezing more profit out their assets than their counterpart at other companies. Likewise, a portfolio of stocks that outperform their beta signifies a very talented investment manager, because he or she has succeeded in beating the market, without accepting undue risk!

How Much Diversification is Enough?

Proper diversification is said to reduce overall portfolio risk by about 70%, which is about all that can be expected. However, just how many stocks are required to sufficiently diversify a portfolio is a matter of debate among financial experts. Ben Graham, in The Intelligent Investor, recommended 10 to 30 stocks. Publications in the late 1960's and early 1970's suggested as little as 10 may do the trick. (See Journal of Finance , Evans and Archer 1968). The most common consensus is 15 stocks, but this number has some very vocal detractors.

Standard deviation is a powerful statistical tool, but it is not the only dimension to risk management. The stock market itself is capitalization weighted. Individual stocks impact the market in relation to their total capitalization (number of shares outstanding times their price per share). This means that larger companies have more impact on the market than smaller ones. Portfolio diversification, on the other hand, is usually accomplished by spreading the risk among a number of companies, in equal dollar amount per company. Therefore, in economic conditions that favor larger companies, it is entirely possible for the market to outperform a well diversified portfolio. In other circumstances, the equal dollar diversified portfolio will provide the more favorable return.

Blind diversification is not the best approach. The stocks used to diversify a portfolio should be carefully selected. Studies have shown that randomly selected, equally weighted 15 stock portfolios can produce a wide range of outcomes. (Link William J. Bernstein). The last two decades of the 20 th century saw the rise of super-performing stocks, such as some of the technology companies. A number of these corporations went from shoestring operations to billion dollar players in a very short period of time. A diversified portfolio, that did not include a least one of these market stars, would have significantly underperformed the overall market.

Therefore, some experts suggest that true diversification is only achieved by owning the whole market. (This could be accomplished through a mutual fund that specializes in replicating a given stock index, or through an ETF). Of course it can also be argued that the amount of diversification required is highly dependent on the skill of the stock picker. In the words of Warren Buffett "wide diversification is only required when investors do not understand what they are doing".

Diversification is more complicated than just adding a few more stocks. The amount of risk reduction is not equal for each new stock added to the portfolio. The greatest risk reduction comes from the addition of the first few stocks. Thereafter the effect gradually reduces, until the addition of additional diversified stocks has very little impact on total portfolio risk. In a study by Edwin J Elton and Martin J Gruber (Modern Portfolio Theory and Investment Analysis”) held that 20 stocks reduced the majority of the risk. Going from 20 to 1,000 stocks only added an additional 0.8% reduction in risk.

The more stocks you have in a portfolio, the less the impact of any big gainers you may have chosen. This is over-diversification is one of the disadvantages of the larger mutual funds. They hold such a large basket of stocks that it waters down their total return. The talent of the fund manager is not great enough to offset the weight of the market place.

Beat the Market or Be the Market

Anyone who is considering investing, whether they realize it or not, makes a decision to either beat the market or be the market. Individuals who intend to beat the market will select a limited number of individual stocks or mutual funds designed to perform better than the overall market. There are hundreds of fund manager in this country alone, each highly paid and supposedly highly skilled. Yet only a few consistently outperform the market as a whole. This phenomenon has led some financial professionals to advocate low cost portfolios that essentially represent the whole market. The theory is that by minimizing portfolio expense and structuring the portfolio in such a way as to mimic the market, the greatest value is passed on to the individual investors.

Everything other investment decision will follow naturally once the decision to be the market or beat the market is made. Investors who wish to beat the market face a substantial challenge. They can choose to make the attempted with individual stock selections or by searching for best performing portfolio managers. Investors who only want the average market return, have a much easier task. They need only search for a mutual fund or ETF that has excellent market correlation combined with the lowest expenses of operation.

Management of investment risk is a complex endeavor and diversification is only part of the story. The other side of the coin is proper asset allocation.

Caution: Much of this discussion herein is based on the work of Harry Markowitz and William F. Sharpe who received a Nobel Prize in Economics for their concepts of Modern Portfolio Theory (MPT) and Capital Pricing Model (CPM). Their theories and analytical tools have spawned thousand of additional studies and encouraged the creation of huge database of securities price and performance histories. The information provided in not complete enough to make any investment decisions and nothing contained in this material is intended as a recommendation of one course of action over another. Our purpose in presenting this information is two fold:

Individuals who intend to invest a significant portion of their assets in the stock market are strongly urged to read, read and read some more on this topic. As you educate your self, as to profit strategies and risk management techniques, an investment philosophy that fits your individual needs and style will emerge. The internet, book stores and various financial publications are rife with investment information: some of it wise, some of it amateurish and some of it conflicting. Just keep reading until it all makes sense. Then you can judge which approaches and methodologies are best for your situation. [Insert Link???Journal of Finance & CFA Journal are to excellent buy technical sources.]

Note: Investment information is available from a licensed stock broker or a mutual fund broker (sometimes they are licensed to sell both). Some insurance agents hold a license for both insurance and securities. These dually licensed individuals are allowed to sell variable life and annuity products. Variable life and variable annuity policies are not saving vehicles. The cash values of these products (except for selected limited options) are comprised of managed stock and bond portfolios and are fully exposed to market fluctuations as well as the gain or loss of the individual stocks and bonds held in the portfolio. In a variable policy the investment risk is completely passed through to the policyholder.

Note: The reader should note that this discussion in not intended to favor individuals who are: securities licensed, insurance licensed or dually licensed. The mere fact that an individual has dual licensed does not, in and of itself, convey any special expertise. Some agents hold dual licenses because they want the flexibility for their clients; others hold only an insurance license because they feel investment products are inappropriate for most of their clients.