We have already discussed the importance of one’s investment returns beating the rate of inflation. The only way of achieving a rate of return above the rate of inflation (or a rate of return above the risk-free rate of return) is to take on additional risk.
It is therefore important for investors to understand the different types of investment risks and the best strategies to minimize the potential negative effects on a portfolio of shares. The most severe negative impact of course being a permanent loss of capital.
Investment risk and risk management strategies is quite a broad and complex subject. Phoenixclub is only concerned with investing in shares of listed companies and risk and risk management will therefore be discussed in the context of a portfolio of shares. We will further keep the discussion very practical and simple.
There are two distinct categories of risks that are underlying equity markets (portfolio of shares);
- Market risk (systematic risk – risks inherent in stock markets)
- Company specific risk (unsystematic risk – risk associated with any one particular listed company or industry)
This article will focus on company specific risk and market 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.
Company specific risk is directly related to the performance of a specific company or industry. Examples of unsystematic risk are regulatory changes, new competitors, recall of a product, etc.
Company specific risk (unsystematic risk) is reduced through diversification. Diversification is the spreading of investment capital amongst different shares and industries (sectors) with the purpose to reduce one’s exposure to any one specific company. Diversification has been proven to be a highly effective way to minimizing specific risk in the share market.
The logic of diversification is that the risk of a portfolio of shares reduces when the number of shares are increased. By owning stocks in different companies and in different industries, investors will be less affected by an event that has a strong impact on one company or industry. If you hold the shares of just one company then you are 100% exposed the fortunes / misfortunes of this one company only. When you add a second share to your portfolio you reduce your risk considerably. Adding a third share will reduce your risk further, but not by as much as when you added the second share.
A portfolio of between 5 and 15 shares spread over 3 to 5 industries (sectors) is generally considered to be adequately diversified. The risk of a portfolio of less than 5 shares is considered unacceptably high and the further reductions in risk achieved by adding more shares than 15 shares is negligible.
It is important that a portfolio is reviewed periodically. The frequency of review will to some degree depend on the confidence you have in your research and selection of shares. Long-term investors will probably find it sufficient to review their portfolios once a month.
Simple diversification as discussed above is effective in reducing the risk of a portfolio of shares, but will not protect you from default risk. Default risk is related to the quality of the underlying investment (share) and is discussed in a separate article.