Posts

Understanding Investment Risk: Impact of Individual Stocks

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.

Unsystematic 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.

Systematic Risk

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

Business Monthly: Ten Common Investment Mistakes to Avoid

  1. Taking Excessive Risk

Many investors gravitate toward investments offering the highest potential returns while ignoring the associated risks.  If your investment loses 50% of its value during a bear market, it will take a gain of 100% just to return to break-even status.  The goal of a well-diversified, balanced portfolio is to reduce market risk while earning steady, consistent returns over a long time horizon.  Minimizing losses during downturns generally produces higher average compounded returns over a long time horizon. Read more

River Hill Magazine: Five Common Investment Mistakes to Avoid

 

  1. Taking Excessive Risk

Many investors gravitate toward investments offering the highest potential returns while ignoring the associated risks.  If your investment loses 50% of its value during a bear market, it will take a gain of 100% just to return to break-even status.  The goal of a well-diversified, balanced portfolio is to reduce market risk while earning steady, consistent returns over a long time horizon.  Minimizing losses during downturns generally produces higher average compounded returns over a long time horizon.

 

  1. Using Stocks to Meet Short-Term Cash Needs

Funds that are needed to meet a specific financial goal in less than a three-year period, and perhaps longer, should not be heavily invested in stocks or stock funds.  Examples of goals are a car replacement, the down payment on the purchase of a home, or even plans for a major vacation.  The logic behind this is simple.  Stocks are quite capable of losing 30% of their value or even much more in a rather short period of time.  When these periods of volatility occur, the odds are that you will not escape the carnage.  Based on historical data, it often takes 2-4 years and sometimes longer to recover from a major market setback.  When your goal is short-term, it is more important to protect your resources than to reach for higher returns.

 

  1. Lack of Diversification

Diversification is the key to managing total portfolio risk and volatility.  Reallocating funds moderately between asset classes that have a low correlation relative to the U.S. stock market can potentially reduce portfolio volatility without significantly sacrificing long-term portfolio returns.

 

  1. Concentration – Keeping Most of Your Eggs In One Basket

A concentrated investment strategy is the quickest way to accumulate wealth as long as you make the correct investment decision.  It is also the quickest way to lose wealth if you make a poor investment choice.  A general guideline is to limit any individual stock to 5% or less of the stock portion of your total portfolio.  An allocation above 5%, while carrying significant risk, could be justified if you are knowledgeable about the specific investment and are confident that this particular investment can outperform the broad market or other alternatives.

 

  1. Stretching For High-Yield At The Expense Of Quality and Stability

Income-oriented investors are frequently attracted to the promise of high-yielding investments.  It is important to mention that investment returns are comprised of two factors.  One factor is the income or yield that is generated in the form of interest or dividends.  The second factor is capital appreciation or depreciation (loss).  Total return, the sum of these two factors, is the bottom-line and all that counts.  If an investment advertises a yield that seems too good to be true, it probably is.  Interest rate or yield is irrelevant if you lose your investment.

 

*********************************

Christopher Parr is a River Hill resident and President of Parr Financial Solutions Inc.- an independent, fee-only financial advisory firm:  www.ParrFinancialSolutions.com

River Hill Magazine: Asset Class Correlation – A Useful Tool for Managing Investment Risk

With U.S. stock market indices at or near record highs and showing increasing signs of stress, it is an opportune time to reinforce the long-term benefits of permanently including some out-of-favor positions in your portfolio.   An investment strategy practicing broad diversification can pay-off with reduced downside volatility and lead to higher long-term returns. 

A Dose of Reality

Periodic stock market corrections are an inevitable part of investing and impossible to time consistently.  Here are a few probabilities to consider based on historical data from John Tousley, Sr. Portfolio Strategist at Goldman Sachs Asset Management:

  1. There is a 57% chance for a 10% stock market correction in any given year.
  2. The probability of at least a 10% market correction increases to 65% chance when the market is trading at an all-time high.
  3. It has been 20 months (as of March, 2014) since the last 10% or more market correction.
  4. Investors who try to time the market end up underperforming by 3%.

What is Asset Class Correlation?

One-way to accomplish broad diversification in an investment portfolio is by carefully selecting different types of investments, technically referred to as “asset classes”, that have a low correlation to the stock market.  Correlation is a statistical measure of how different investments behave relative to each other.  Correlation mathematically ranges from +1.00 to -1.00.  A correlation of +1.00 indicates 100% perfect correlation and implies that a 10% gain in one asset class could be expected to also lead to a 10% gain in another asset class.

A value of -1.00 indicates perfect negative or opposite correlation.  For example, rain and umbrellas have a correlation close to +1.00.  Rain and sun have a correlation closer to -1.00.  The correlation between rain and scheduling a routine dental check-up is perhaps 0.00 and implies that these two items are uncorrelated and likely have nothing to do with each other.

The table below generated using Morningstar Principia Pro software shows the degree of monthly correlation between the returns of various asset classes for the five-year period ending 12/31/2013.  The asset classes selected for this analysis are (1) Bonds, (2) Commodities, (3) International Stocks, (4) Emerging Market Stocks, (5) U.S. Small Company Stocks, (6) U.S. Large Company Stocks, (7) Cash, and (8) Gold:

Asset Class Correlation

This analysis presents a case for including low-correlated assets including cash, bonds and gold in a portfolio to reduce the overall stock market risk of the total portfolio.  Permanently keeping a portion of your long-term investment portfolio in low-correlated investments can reduce risk and actually enhance long-term returns by helping to stabilize the downside.  On a final note, please keep in mind that correlations are not fixed and can change over time and amid different global economic conditions.

Christopher Parr is President of a local, independent, fee-only wealth management firm:  www.ParrFinancialSolutions.com

This article was written for the June issue of River Hill Magazine.