What about diversification? How can we deal with risk in assets and what is risk anyhow?

In finance risk is an unavoidable reality that must be taken on taken if a return of any description is to be attained. However the level of risk exposure can be mitigated through astute risk management, tailored to investors needs and appetite for risk. An investor must understand the relationship between risk and return if he/she is to be successful. It is very prudent to examine risk and diversification at a time of considerable economic instability, primarily highlighted by volatility, a reflection of market risk, in financial markets of late. The Eurozone crisis is entering a critical stage, major European economies such as Italy and Spain have seen their government debt trade above 6%, a level that makes the costs of borrowing for these respective countries unsustainable. Yet sadly it appears that until these countries display serious fiscal discipline going forward the European core of France and Germany look unlikely to foot the bill. A break up of the euro, no matter how implausible would have a devastating effect on the global economy, almost certainly leading to a worldwide recession. This systemic risk has prevented US stocks from going higher in recent weeks despite the US economy showing promising signs that have indicated a steady recovery. While all portfolios must contend with this unavoidable risk the more risk averse investors may seek to remove unnecessary risk by following an investment strategy that follows modern portfolio theory.

For the sake of clarity it is probably wise to begin with risk itself and its defining features. When I refer to risk in this piece I am talking about the umbrella term of financial risk unless otherwise stated and the various types of risks that are associated with finance in general, be it personal or corporate. While there is no specific definition of risk in finance it is generally regarded as the probability that an investments return would be different to what was expected. This includes the probability that a considerable portion or indeed all of the original investment could be lost.

An investor’s appetite for risk can be effectively highlighted in the trade-off between risk and return, a trade-off that will dictate the level of diversification in a portfolio. Low risk is more than often than not inextricably linked to low returns and the same can be said about the high risk and its expected returns. The following chart displays this relationship excellently, a portfolio with a high standard deviation is unavoidably linked to high risk and the potential pitfalls that go with it.

At the lower end of the spectrum one could, in theory, chose an investment with no risk of financial loss as defined by the risk-free rate of return. Essentially it represents the minimum rate of interest that an investor could expect from a risk-free investment, the best known of which would be interest from three month U.S. treasury bills. However in practice this is not the case as even the safest investment must carry a minimal amount of risk. For instance U.S. treasury bills have been linked to the risk-free rate of return because the likelihood of the U.S defaulting upon its debt obligations is considered extremely unlikely. That being said one must recall July 29th this year and how close the U.S. came to defaulting upon its debt, the U.S. house of representatives finally passed a bill allowing a raising of the debt ceiling just two days before the country would be unable to meet its debt obligations. This event brought into focus the credibility of U.S. treasury bonds and its position as a benchmark for the risk-free rate of return.

While I may have alluded to specific risks in the proceeding paragraphs, one cannot grasp the realities of risk in finance without understanding the two fundamental types of risk that investors must tackle. Firstly systematic risk is the risk that is linked to aggregate market performance and cannot be removed through diversification. It is a risk which is caused by factors that affect the prices of virtually all securities, although in different proportions (Scott 2003). An asset’s exposure to systematic risk/market risk can be measured mathematically and expressed as a beta, a coefficient which examines the sensitivity of a given stock when compared with the market as a whole.

To help lessen the effect of risk, diversification is employed by spreading an allocation of investments over a variety of asset classes, industries and categories. A perfectly diversified portfolio is characterized by little or no correlation between individual investments. Thus the impact of any one event is effectively hedged by the remaining investments. It is generally the case that bond and equity markets move in opposite directions to one another, thus a combination of the two asset classes could potentially negate the impact of unwanted market swings. The above graph examines the effectiveness of diversification on systematic and unsystematic risk within a portfolio. In addition it also takes into account portfolio variables such as the average annual standard deviation of stocks and the number of stocks contained within a portfolio. Unsystematic risk refers to a specific risk that is unique to a particular asset or investment, a common example is the strike of company employees having an adverse effect on a company’s share price. As the graph displays, unsystematic risk can be diversified away but the standard deviation of the portfolio follows the law of diminishing returns. Despite ones best efforts, diversification becomes ineffective once it reaches the base level of systematic risk, in this case 19.2.

      As we have examined thus far investors are forced to confront risk in two distinct forms, systematic and un-systematic, the latter being the only one which can be successfully diversified through astute portfolio management.