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Diversification: Making Sure You Get Paid for Taking Risk

sunglasses

Investing is the art and skill of putting your money to work so that it creates a profit, allowing it to grow.  As it relates to stocks, you are giving a firm cash in exchange for an ownership stake in the firm, which entitles you to a share of its future profits.  Shrewd investors assess the risk of their investments and invest their funds only when they get compensated for the risk they are taking, and will generally prefer those investments that provide the greatest return opportunity for each “unit” of risk assumes.

In other words, like a smart gambler, rational investors seek to maximize their expected return for a given level of risk (or minimize their risk at a given level of expected return).  This assumption is a pillar of the Capital Asset Pricing Model (“CAPM”), one of the most widely recognized theoretical frameworks that explains how markets operate.

Makes sense, right?

CAPM does not perfectly explain market behavior.  In particular, CAPM assumes that markets are “efficient” and that all stocks trade at a price that perfectly reflects their risk/return profile.  Studies have revealed that, in fact, many stocks are imperfectly priced, leading to favorable opportunities for skilled investors.  Nonetheless, CAPM does provide useful insights for all investors, particularly as it relates to the prudence of diversification.

CAPM & Diversification

CAPM says that while stock prices reflect the risk/return profile of a stock, it only considers “non-diversifiable” risk in this pricing – that is, only those risk that cannot be eliminated through diversification.

Here is a simple example that demonstrates this concept.

Example

Suppose that you have an opportunity to invest in a store that will sell umbrellas.  This investment will have significant risk relating to weather conditions – when it rains, you expect sales (and profits) to increase, while on sunny days you expect sales (and profits) to decrease.  This high degree of uncertainty may lead you to believe that, as an investor, you should be entitled to price your ownership interest to reflect this additional risk.

However, CAPM says otherwise,

In particular, you can easily diversify away this risk by investing in another store that sells sunglasses (the sales (and profits) of which increase on sunny days, and decrease on rainy days, just the opposite of umbrellas).  CAPM realizes this and says that investors should not be compensated for weather risk.

What if this were not the case, and investors were rewarded for weather risk?  Well, smart investors would split their investment between the umbrella store and the sunglass store, which would eliminate weather risk, and pocket the additional return for the weather risk without being exposed to this risk.  This is what is referred to as an “arbitrage” – the ability to realize a profit without being exposed to risk.

In a perfect market, investors would realize this very quickly, bidding up the prices of both the umbrella store stock and the sunglass store stock until it reached a price that ignored the weather risk.

What This Means to You & Your Investing Strategy

Many investors see stocks that have performed extraordinarily well, rising to prices that are many multiples of their price just a few years ago (e.g. Apple Computers) .  This history seduces many into seeking the next stock that will perform in this way, and place a substantial portion of their wealth in the best prospect.  For this investor, diversification is the enemy – by spreading your wealth across many investments, the chance of realizing spectacular returns grows smaller.  In other words, let’s make a big bet on just a few firms and hope for a huge payoff.

The problem with this strategy is that we are taking a risk for which we will not get compensated.  Firm-specific risk is generally believed to be something that can be eliminated through diversification – for each firm that has something uniquely good happen to it there is another firm that has something uniquely bad happen to it.  Therefore, as was the case with our umbrella store and sunglass store investments, the price at which we can secure such an investment will not reflect this additional risk that we are bearing.

Conclusion

Being an astute investor, you only want to take risks that you are going to get paid for taking.  This means staying away from big bets on a few select stocks, and instead holding a well-diversified portfolio.  Even great value investors such as Warren Buffett, who seek out attractive stocks, hold well-diversified portfolios that span many firms across different industries.  The best way to achieve this diversification is through indexed funds, which can allow you to invest in a large portion of the overall market at a very reasonable cost.

You won’t strike it rich overnight with indexed funds, buy you are playing the house odds smartly, which means that over the long run you will probably be better off.

Posted by

John Bevacqua on April 8, 2012

Filed Under

Investing

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Being an astute investor, you only want to take risks that you are going to get paid for taking. This means staying away from big bets on a few select stocks, and instead holding a well-diversified portfolio.


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