We have already pointed out in the article on “specific risk” that there are two distinct categories of risks that are underlying equity markets (portfolio of shares);
- Market risk (systematic risk – risks inherent in stock markets e.g. volatility)
- Company specific risk (unsystematic risk – risk associated with any one particular listed company / share)
This article will focus on market risk and company specific risk is discussed in a separate article. The concern here is with “risk management” and not with portfolio structuring to “optimize the potential return” of a portfolio. Portfolio structuring with a view to optimize returns is discussed in a separate article.
Market risk (systematic risk) is the possibility of an investor experiencing a loss due to factors that affect the overall performance of the financial markets. Examples of market risks are natural disasters, recessions, political turmoil, etc.
Shares and industries react differently to different market conditions and a portfolio of different shares and industries will therefore provide some degree of hedging against market risk. Market risk can however not be sufficiently reduced by diversification alone.
Market risk (systematic risk) is reduced through the application of time diversification and other more sophisticated tactical asset allocation strategies. Many empirical studies have been conducted over time which proved time diversification to be very effective in reducing market risk and we will limit the discussion to time diversification.
Time diversification has to do with “time in the market”. Equity markets are inherently very volatile and the possibility of suffering a capital loss is high. The risk of a loss is generally much higher for short-term investors than for long-term investors. This risk of a loss is greatly reduced by time in the market.
The concept of time diversification refers to the decrease in risk which is achieved when growth assets are held for longer periods and this has been proved by many studies of different markets and over wide ranges of investment periods. The evidence is overwhelming and there is no point in exploring this fact further. The graph below illustrates the relationship between “probability of a loss” and “holding period in years”. The figures are indicative only and for the purposes for illustration. Real market figures will vary slightly from these.
Research has further shown over and over that the growth phases of the market (periods of rising share prices) are on average much longer than periods of decline (periods of declining share prices) and that each time the market bottomed-out it has risen to higher heights than all the periods before.
Research also shows that the JSE, over periods of 6 years and more, is not as risky as is generally believed and that the potential for superior returns is well worth the risk.
Investment professions consider “the TIME that you hold your investment for in the market” one of the biggest factors that contribute to your wealth creation and overall probability of success on the stock market.
Time diversity is simple to understand and apply and effective both as a risk management strategy and to enhance your overall chances on success in the market.
“Phasing in” of investments is one more form of time diversification. Equity markets are very volatile and unpredictable and can easily and unexpectedly move against you just after you have made a share purchase. Investors with a large lump sum of money to invest should rather “phase-in” their money into the market over months rather than buying all the shares in one go.
Market entry is also very important for success investing. It is however impossible to determine when the market will reach a bottom. It therefore makes sense to phase-in money during times that the markets are at a low instead of following a “wait and see” approach and running the risk of not benefiting from the pending recovery.
A long investment time horizon is not only effective in managing market risk, but alos enhances your probability for success in the markets.