The Risk Management Lessons: 1. Advanced Diversification

by: Matthew Allbee

Summary

Over the Summer months, I will be running a weekly series going over everything I can possibly think of that can help investors better manage risk.

In this first installment, I discuss the basics of diversification and then go on to explain more complex methods of using diversification to pinpoint investments that would otherwise be off-limits.

I discuss how diversification can be used to immunize your portfolio from market risk and how to protect yourself from certain risks you want to avoid in your investments.

Hello everyone,

This will be the first installment of a weekly series I would like to run every Friday through at least the end of the Summer on risk management. In it, I plan to cover everything an informed investor would need to know about risk management. Throughout this process, I would greatly appreciate any feedback you all would have to improve upon the series (and possible future ones) throughout the coming months.

I will begin with basic topics, such as this article on diversification and how to use different classes of investments to determine the risk of your portfolio, and move on to discussing such things as the Sharpe ratio, Modern Portfolio Theory, and other more advanced topics. All of this will be written at a level which anyone should be able to understand, as I believe it could help a great deal of investors perform better in the markets (I know I've taken losses from stupidly ignoring risk management techniques in the past.) If you'd like to keep-up-to-date with this letter, please feel free to follow me.

Without further ado, Lesson 1: (Advanced) Diversification

Surely, if you find yourself on this site, you have at least a passing knowledge of what diversification is and how it works. What many don't realize, though, is just how powerful diversification can be when employed skillfully. This "basic" investing rule can in fact completely immunize your portfolio from market swings, pinpoint investment risks you want to take on while nullifying those you don't, and even simultaneously increase your return while lowering your risk. In this article, I'll cover how you can use "advanced diversification" to achieve some of these goals (the last will have to be saved for a future article involving Portfolio Theory).

Let's start with the very basics: how does diversification work? Imagine you have $100,000 that you want to invest in the stock market. With this investment, you can invest in one of two ways: invest all of it in a single stock or split the money into 10 different $10,000 bundles and invest in 10 different stocks (including the one you could invested in by itself). You believe each of these stocks will perform exactly the same and gain 10% in value over the next year. What are the consequence of each investment strategy?

As you may know, predictions are not always reality. The following chart shows the actual returns of each company's stock under two "scenarios."

Now, let's look at what the difference is between the returns of these two strategies in both scenarios. First, what would happen if you invested only in company 1?

This is pretty easy to calculate. Obviously, since all of your money is invested in this single company, your return will be whatever the company's stock does while you're invested. So, in scenario A, you earn $50,000 over the course of the year, but in scenario B, you lose $50,000. This dramatic risk/reward relationship is common in undiversified portfolios.

Now, let's look at the second strategy. Since, you only have 10% of your capital in company 1, you only win or lose $5,000. Further, while you weren't so great at predicting each individual company, your average prediction was spot on. All of the other investments together average the 10% you were expecting, although many individual stocks deviated wildly from it. Due to the fact that you were split so evenly among a fairly large group of investments, with the second strategy, you earn either $15,000 or $5,000 - with no possibility for losing money.

The difference is that the second strategy is diversified. That is, it invests in many securities rather than just one or a few. The difference between diversified and undiversified portfolios can be striking. In general, undiversified portfolios tend to exhibit the same behavior as the first strategy. Sometimes they have magnificent gains, but other times, they suffer devastating losses. On the other hand, diversified portfolios are more like the second strategy. They exhibit much more modest gains, but are much more reliable.

At this point, you may be thinking that it could be worth the risk to try the first strategy. Lured in by the possibility of huge returns, many people fall into this trap. Unfortunately, all that these people are really doing is gambling. In essence, they are hoping to hit the jackpot before they go broke.

To emphasize the point, let's see what happens for the two portfolios if scenarios A and B alternate each year, with half of the years following scenario A and the other half following scenario B.

As you can see, while portfolio one may start off with the greater return because of its concentration in a single, well-performing (and volatile) asset, in the long term, it actually loses money when company one doesn't do as well as was hoped for. On the other hand, portfolio two churns out modest, consistent gains year after year, even though it also is invested in company one. The other, successful investments offset the loss for consistent profits.

This is the gift of diversification. Without it, losses can quickly pile up and drown your portfolio, but a diversified portfolio is protected from wild swings in any single investment by only having a small portion invested in each security.

Creating a Market-Neutral Portfolio

Now that we have some of the basics down, let's see how we can enact one of the more interesting powers of diversification: immunizing a portfolio from overall market fluctuations.

In order to do this, we need to "diversify away" market risk, or the risk that general market swings will adversely affect your investment. To do this, we look at a metric called beta, which measures how correlated a security is with the overall market, usually represented by the S&P 500. A beta of less than 1 signifies that the security moves in the same direction as the market but is less volatile, a beta of more than 1 signifies that it moves in the same direction but is more volatile, and negative values signal that it moves in the opposite direction of the market.

In order to diversify away market risk, we need a portfolio with an average beta of 0. That is, we need to create a portfolio that is, as a whole, completely unaffected by the market. To do this, we must find investments with varying beta values.

After we have found suitable investments, we simply must find a way to allocate our portfolio with these investments so that the average beta value of the portfolio is as close to 0 as possible. For instance, if we had three investments, A with a beta of 2.0, B with a beta of -1.0, and C with a beta of 0, we would want to have twice as much invested in A as in B, and about a third of our portfolio in C. This produces a portfolio with an average beta of 0.

When doing this, though, it is important to remember to keep in mind diversification between investments as well. For instance, a portfolio with 50% allocated to a security with a beta of 0.5, and 50% to a security with a beta of -0.5 should be immune to market swings, but it would certainly not be diversified. Instead, you should find many investments with varying betas and create a zero-beta portfolio by combining the many pieces in a relatively even configuration.

Pinpoint Investment Risks ("Hedging")

Lastly, let's look at how we can use diversification to pinpoint investment risks we want to take on while nullifying those we don't. For instance, you may want to bet on the upcoming Brexit vote failing by investing in the Pound Sterling, but are afraid of the effect that changing interest rates may have on your investment. How do you diversify away the interest rate risk?

This is one of many situations in which you may want to "hedge" against a certain type of risk. For this, you will need to find a similar investment, except that it benefits from the event that you are trying to get away from. This can certainly be a challenging process.

For instance, you may believe that an oil miner will do well, but are worried about the negative effects that falling oil prices could have on them. To combat this risk, you may choose to buy the miner's stock and sell short an oil price-tracking ETF, such as USO. With this, you can benefit from the increasing stock price while being protected from the risk of falling oil prices.

It should be pointed out that, in hedging away a risk, you also hedge away any chance of benefiting from the risky event. Using the previous example, if the price of oil goes up, you won't be able to profit from the effect it has on the miner's stock price, because the money you lose on the oil ETF will cancel out any profit you make.

Hedging can be a vital tool for those who can master it. Some risks may take some ingenuity to hedge, such as the risk of a tornado in Colorado shutting down a manufacturing plant. In fact, this is partially what futures and options markets were created for. That, though, is for another week.

Thanks for reading,

Matthew Allbee

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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