The Only Guide to a Winning Investment Strategy You'll Ever Need: The Way Smart Money Invests Today by Larry E. Swedroe

Author:Larry E. Swedroe [Swedroe, Larry E.]
Language: eng
Format: epub, pdf
ISBN: 9780312339876
Amazon: 0312339879
Publisher: St. Martin's Press
Published: 2005-01-02T06:00:00+00:00

Diversification of Risk

There are two times in a man’s life when he should not speculate: when he can’t afford it, and when he can.

—Mark Twain, Following the Equator

Every investor is familiar with the saying, “Don’t put all your eggs in one basket.” No matter how good an investment seems, few individuals would construct a portfolio that consists of just one asset. Even if one believes that the risk of being wrong is very small, the cost of being wrong is too great to make that big a bet. Conversely, even when the odds are stacked against them, as at the racetrack or in a lottery, individuals will make an “investment” if the cost of being wrong is small. This type of behavior demonstrates that investors are not risk neutral; in fact they are risk averse, and prudent investors spread their investment dollars across various investment alternatives. This process is called diversification of risk. We will now explore, using three easy steps, how one can most effectively use the principle of diversification to reduce risk.

Let’s begin with a portfolio that consists of only the stock of one company, General Motors. Despite the size and strength of the company, that would be a very risky, and potentially very volatile, portfolio. In order to reduce the risk of the portfolio, we need to diversify. We can do so by adding Ford, but this type of diversification is not very effective because both companies are susceptible to the same types of business risk. Since both are likely to respond to changes in the economic environment in a very similar manner, their stock prices are likely to move in a highly correlated manner. (If they moved in exact tandem, they would have a correlation of +1.) Not only are they likely to move up and down at the same time, but the size of their price movements are also likely to be similar (but not identical). While we slightly reduced the risk of our portfolio by adding a second security, we did not really accomplish our objective.

We can more effectively reduce the risk and the volatility of our portfolio by adding the stocks of companies from different industries, preferably ones that do not respond in exactly the same way to business cycles. If assets tend to do well or poorly at the same time, they have high correlation. If the opposite is true, then their correlation is lower, and it may even be negative. Ideally, we would like to find assets with negative correlation. The addition of assets that have perfect negative correlation could completely eliminate the volatility of the portfolio. Although assets that have negative correlation are very hard to find, risk can be reduced by including in a portfolio assets whose correlation is less than perfect—and the lower the better.

Even without any understanding of the math, I think you can accept that an investor would have reduced the risk of our sample portfolio by adding Merck (a drug company), Citigroup (a financial institution), or AT&T (a communication company) to the portfolio.

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