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The Nature of Risk and Concentrated Positions

By: Frank Armstrong

By: Frank Armstrong, CFP

Finance 101

The market never rewards an investor for any risk that could be diversified away. All risk and return assumptions are based on a diversified portfolio. Any stocks with similar size and distress characteristics are assumed to have similar returns. However, the risk in a single stock is enormous, while the risk in a diversified portfolio.

For example, the big lesson investors can take from the Enron disaster is the danger or concentrated positions and the value of diversification. The impact on your portfolio should have been negligible. If not, shame on you. To an investor, the Enron fiasco was a business risk as opposed to a market risk. Business risk can be almost entirely diversified away. So, investors should see the collapse of even a major company as a non-event. A properly diversified portfolio bears the un-diversifiable but quantifiable risks of market, size, and distress risk, nothing more. Economists, who love to use big words for the sole purpose of intimidating the rest of us, would call un-diversifiable market risk a systemic risk.

Enron used to be a large growth stock. It had the same expected rate of return as the large growth market, about 11% or so. But the risk of that single position was exponentially larger than holding the entire market. Even measured during a single minute, hour, day or week of “normal” trading, the risk of a single issue is far higher than the market. Why would anyone take all that risk?

Said another way, risk and return are only related when we speak about a diversified portfolio of stocks holding similar size and value characteristics. Risk and return are not related when we speak about only one stock. There is really no way to quantify the business risk of a single issue. Who could have predicted such a spectacular business failure? But, to paraphrase one of my favorite bumper stickers, Risk Happens!

To the holder of a single issue portfolio, the probability of a total meltdown is small, but the consequences are catastrophic. Because there is no additional reward for bearing this avoidable risk, it is irrational to accept it.

Diversification is the single most important risk control technique available to investors. Rational investors will seek the widest possible diversification.

The Global Market Portfolio

To digress back to Finance 101 again, Capital Asset Pricing Model (CAP-M) finds that the most efficient equity portfolio, and the one that we should all wish to hold, is the global market basket, or your properly weighted share of all the world’s equities. In this case, efficient means that it has the highest return per unit of risk possible of any portfolio that we might form.

An investor must have a compelling reason to deviate from the global portfolio. They do so at their peril. Any portfolio other than the global market basket is a big bet against the efficient market. History would show that these bets are unlikely to pay off with reliable additional return. In fact, we can reliably expect to under-perform the market over the long haul. While there are always some winners in this game of chance, the odds are heavily stacked against the player.

Investors that hold concentrated portfolios are bearing far more risk than justified by the expected return. Concentrated issues include individual stocks, industry, sector and geographic concentrations. There is no separately priced risk element for any of these concentration issues, and no additional return to be anticipated by bearing these risks. We have seen the risks materialize in the near past as the S&P 500, dot.coms, and tech stocks in turn soared then crashed, leaving puzzled investors wondering what happened to their decimated portfolios.

Business risk is priced right into the cost of the global market portfolio. We assume that some failures will occur. Investors are rewarded for bearing that risk, along with others, by an equity risk premium or additional return above the zero risk asset. But, to repeat, the equity risk premium assumes a fully diversified portfolio.

If you are wondering just how much the Enron collapse impacted the global portfolio last year, here is an example from our firm’s best cut at the global portfolio*. Of the nine equity asset classes we hold, only one (US Large Company) had a position in Enron. On May 31, 2001 that position accounted for just 0.34% of the fund. Overall, because US Large accounts for only 10% of our equity portfolio, that position was just 0.034% of our global equity exposure.

In a typical retirement portfolio, comprised of 60% equity and 40% bonds, your portfolio would have held 0.0204% in Enron. That’s a loss of 2/100 of one percent! Why would anyone have wagered more on a single stock?

Summary

Diversification works. It is the investor’s primary defense against disaster in his portfolio. In a well diversified portfolio, the failure of any single company is a non-event. The global portfolio reduces equity risk to its lowest possible limit, and it does this while delivering the full measure of equity return.

*** The example is for general educational purposes only, and is not to be considered specific investment advice. We overweight small and value firms in our global equity portfolio model. All the normal disclosures apply: Past performance is no indication of future performance. The example illustrates only the impact of a specific holding on the entire portfolio, and does not represent total performance of the portfolio, the performance of any specific portfolio, or the performance of our total funds under management. The impact of fees are not included.