Diversification: Systematic Risk and Unsystematic Risk
June 23, 2014
Akira Kondo
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Diversification is probably the first step that you want to start off when constructing your portfolio. You hear such sentence, “diversification is free lunch” while watching CNBC. Yes, you don't have to pay anything for that diversification (but maybe there are some additional commission fees because you have to make multiple transactions to compose that diversified portfolio).
If you own one single stock, such as Amazon.com (NASDAQ: AMZN), from the start of this year, your only Amazon imbedded portfolio with initial $10,000 value (Assume 25 AMZN shares x the stock price of $397.97 on Jan. 1, 2014) now becomes $8,100 or down nearly 20 percent ($324.20 per AMZN share as of Jun. 21, 2014). That is already a lot of loss in the portfolio. You need 24 percent again to get back to breakeven or an additional 5 percentage gain to restart your portfolio.  Performance of AMZN Stock over Past Six Months,
Source: Yahoo! Finance
Investors often make mistakes here. If a stock is down 20 percent, you need 20 percent up to reach breakeven. That is wrong! There is one easy way to remember: if your stock is down 33 percent, you need 50 percent to get back to breakeven. Yes, 50 percent to get back to break even if you already lose 33 percent. Expecting 50 percent up in coming months requires greater patience but your patience may not eliminate that loss.
Many investors are afraid of realizing losses or they hate to accept any losses. I believe realizing a loss at some moment is a way to become a smarter investor. If you can cut your loss earlier, you can deploy that money into a better stock. There are at least 500 stocks to choose from the popular S&P 500 index or nearly 3,000 stocks to choose from the NASDAQ exchange. Then, diversification starts to work if you can choose more stocks from various stock exchange markets, but mostly from NYSE and NASDAQ. If you have $10,000 to start off your investment, you can think of dividing this amount into five different stocks that you can think of. You can still purchase Amazon stock but this time you spend $2,000 out of your $10,000. That is about six AMZN shares instead of the 25 shares. After choosing your favorite Amazon stock, you can continue to choose more stocks. What is your next choice? There are still four spots available to invest. Lesson here is that you should avoid buying technology stock. Amazon is considered to be a part of technology and a part of retail. It is confusing somewhat. Though it is okay to buy a technology stock, such as Apple (NASDAQ: AAPL), if you think that Amazon is a retail play, which I really think. |
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 Source: Yahoo! Finance
Since you are investing, you may think of investment banks. You can choose, for instance, JP Morgan Chase (NYSE: JPM) as your second choice. This company is probably well known in the east coast area or some people think of “Chase credit cards.” One of the leading CEOs in the United States, Jamie Dimon, has been running the company since 2005. It is not required to know the name of CEO, but at least you should know something about the company, including financial statements. When you start owning this stock, then you will realize that you are getting dividends every quarter. It yields 2.80 percent (as of June 22, 2014).
Now, you want to think of dividends. There are many companies that are paying out dividends to investors. The best source of finding dividend stocks is NASDAQ.com, where you can find their yields as well as historical payouts. High dividend-yielding stocks tend to have limited downsides, though depending on types of stocks. Importantly power of compounding really starts to encourage your investment when owning the stocks that increases payout annually. These are two good reasons to own have dividend stocks. <Read Apple’s Dividend Growth and Power of Compounding for more details about the importance of dividends>  Source: Yahoo! Finance
Now you have technology/retail and a bank in your portfolio. Let’s look for the other industry with a high yielding stock. Ensco International (NYSE: ESV) is one of my favorite picks for many years. It is an offshore drilling company that hunts for precious deep-water assets. The stock currently yields a handsome 5.40 percent (as of June 22, 2014). That is nearly twice higher than that of JP Morgan. Is it really paying every quarter? Yes, so far. This company pays out dividends every quarter and increases the dividend amount every year, which power of compounding is also imbedded.
Again, there are many stocks that are paying out dividends. For instance, McDonald’s (NYSE: MCD) can be the forth pick in your portfolio. The company has both positive and negative images; however, the company’s business is performing well out of the United States. It sells burgers globally but now sells more and more healthier meals that attract customers across the globe. The stock yields 3.20 percent (as of June 22, 2014) and the company also increases payout annually for over many years. That is more consistent than JP Morgan and Ensco International. |
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 Yahoo! Finance
Your last pick can be anything. You can bet on healthcare, foreign, or small cap stock. If you are a highly risk-averse investor, you can choose the former one. Both foreign and small cap stocks require greater patience. By owning five different stocks at the same time rather than just owning one, you will reduce the investment risk in your portfolio. That is free lunch. If the economy is hit by a crisis, Amazon, JP Morgan, and Ensco may fall while McDonald’s as well as a healthcare stock may hold on well. In the meantime, JP Morgan, Ensco, and McDonald’s still pay out dividends to support your portfolio value.
According to Investor’s popular book, “A Random Walk Down Wall Street,” the investment risk gradually eliminates as you add up more stocks in your portfolio. It is an academic proof as well and your diversification in your portfolio should reduce risk. Though what you can reduce is so called, “unsystematic risk” or “diversifiable risk.” The other risk is “systematic risk,” which you cannot reduce because this risk is generated by the market and the economy. Thus, you should take advantage of reducing the unsystematic risk by adding up five different stocks to enjoy your free lunch. In fact, more and more stocks you have in your portfolio reduce the unsystematic risk. Owning 10 different stocks is far less risky than owning five stocks. Composing of 30 stocks in your portfolio starts to eliminate the unsystematic risk substantially. Systematic Risk and Unsystematic Risk
Systematic and Unsystematic Risks. Sources: Burton G. Malkiel, "A Random Walk Down Wall Street," Norton, 2003. Bodie, Kane, and Marcus, "Investment," McGraw-Hill, 2005.
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However, it does not make sense owning 30 different stocks in your portfolio as an individual investor. If you buy 30 stocks, you have pay 30 commission fees when you buy and when you sell. Plus, you will also be busy checking up your stocks daily basis while your productivity at work may become lower, which may reduce your annual bonus. If you have $50,000 or more to invest, you can start to add up more stocks, say up to 10 or 15 stocks, which would be still controllable than owning 30 stocks. You should think of your dairy work in priority and you do not want to reduce your productivity by adding up too many stocks.
As investment products and services are developing fast over past years, you can diversify your risk by much easier way. If you dislike buying five different stocks or do not know what to choose, you can just buy ETFs, which stand for Exchange-Traded Funds. SPDR, known as Spider, offers S&P 500 stocks in one basket under SPY ticker. It nicely follows the S&P 500 index and you now own 500 stocks in one ETF symbol. Vanguard offers the similar ETF under VOO symbol. Though this article does not discuss asset diversification, you can add Vanguard Total Bond ETF in your portfolio to increase bond exposure. This ETF is powerful because buying bonds are not easy unless you have a premier investment account and good knowledge in trading bonds. This Total Bond ETF is right for you that bonds are already diversified and that will help your asset allocation strategy easily. Although you cannot eliminate the risk when investing stocks, you can still manage your risk by adding up stocks and these stocks should be selected from different sector. Plus, you can manage your dividends by choosing dividend stocks, which you can easily find from NASDAQ.com. Be sure to understand that power of compounding really kicks off if you select the stocks that consistently increase dividend payouts. Do not have too many stocks in your portfolio otherwise you cannot manage them all and your productivity at work become lower. Diversification is free lunch and this free lunch should be imbedded in your portfolio. Akira Kondo is long AAPL and ESV. |