A long, long time ago, way before the first computer mouse was invented, investments were seen and understood in a very linear and simplistic way: What returns would I get for accepting certain levels of risks?
In this article, I'll be briefly describing the concept of risk and return, and how they work together, as simply as possible.
The Linear Relationship Between Risk and Return: Put more eggs in other baskets = achieve zero risk on my portfolio?
It was always thought that, as you diversify your investments (e.g: owning stocks in different industry sectors), your risk level could go all the way down to...possibly zero, while achieving some level of return. At least that was what this linear relationship would assume.
However, there's no free lunch in this world.
No Free Lunch
There is a limit to diversification of your investment portfolio in the context of risk reduction. Even if you diversify as much as humanly possible, the law of diminishing returns will kick in: You'd have to face increased costs of transaction, spend more time and energy monitoring your portfolio and the different sectors/industries/companies, etc.
Defining 'Risk': Introducing Systematic and Unsystematic Risk
Since your portfolio risk can never, in reality, reach zero risk, you must be wondering why it was preached to hold a portfolio with diversified securities in the first place. Let me clarify the confusion here.
There are two kinds of 'risk': Systematic and Unsystematic Risk.
When financial literacy bloggers talk about risk, it is usually unclear if they refer to systematic, unsystematic, or both types of risks. In Finance, there is a clear definition for both systematic and unsystematic risk:
As its name suggests, these risks are unsystematic. They don't fall into one "system": they are uncoordinated, disorganised, random, and fragmented risks. In layman terms, it is the risks that may affect one company but doesn't affect the other (in the same time period).
An Example of unsystematic risk:
Company / Business Risk
Example: A Food and Beverage company named Cafe XYZ became the talking point of the month for the rat infestation that occurred in one of their chain outlets. Upon knowing this news, the company's shares took a hit and plunged 50% in value.
It is unsystematic because while Cafe XYZ, a Food and Beverage company, suffered a dip in value, this news of their rat infestation did not have an impact in other Food and Beverage companies. It only affected this company which owns Cafe XYZ.
Example: ABC Company is a Pharma company, and a sudden rioting event resulted in a huge unrest and temporary (but prolonged) closure of their pharmaceutical factories. This results in plummeting stocks and lower stock prices.
If ABC company's only source of revenue came from their ability to produce goods from their factory, it would have to face huge losses. But, if ABC company has diversified their business into the transportation industry, they've effectively spread out its potential financial loss due to the riots at their factories.
It is nearly impossible to anticipate and predict the source of any type of unsystematics risk or about how and when it is going to occur to a particular company.
As its name suggests, these risks are systematic. Unlike unsystematic risks where one event in a FnB company doesn't affect the entire Food and Beverage Industry as a whole, systematic risks affect the entire market. Common examples include the COVID-19 pandemic, natural disasters, interest rate changes, etc.
Systematic risk is the inherent risk that comes along with investing in the stock market. They are categorized by risk factors that simply cannot be helped. Since unsystematic risks are s unavoidable, the chances are high that investors will eventually take a hit due to systematic risk at one time or another. After all, wars, weather events, and natural disasters happen.
The Minimum Risk Assumed
This is the minimum risk that investors assume when they enter and participate in the stock market. It is the risk that cannot be mitigated by portfolio diversification. Spreading out an investment portfolio across many types of financial instruments and sectors of the market will not lessen the risk of investing, if we're talking about systematic risk.
Hence, when you look into diversifying your portfolio, keep in mind the minimum risk you assume (the systematic risks) when you enter the stock market.
Enough talk about Risk. How about Returns?
Now that we've established the difference between unsystematic and systematic risks, let's talk about returns. You've probably heard of the phrase, "High Risk, Higher Returns", which associates risks to returns in an overly simplified manner. It assumes that by taking on higher risk securities, you will likely receive higher returns on your investment. If you're a fledgling investor or have little to no finance background, this would sound like an appealing investment opportunity. After all, who wouldn't want higher returns on their investments?
This concept makes accepting higher risk investments look like a one-way express ticket to ultimate wealth, if you ignore the high risks associated with it.
As I've described earlier, there is always a level of risk you assume when you enter the stock market. By accepting higher risk investments, you expose yourself to potentially high losses and returns on your investment.
So how do we go about balancing risks and returns on an entire portfolio of securities?
Earlier, we talked about the ancient way of relating risks to returns in a simple linear relationship. Thankfully, this is not the model we rely on today. In the 1950's, a brilliant man named Markowitz took all the securities in the market and measured the relationship of its returns to its risk, one at a time. The first time he did it, the plot on the graph probably looked like this:
Then, each security was then paired with a second security, forming a plot of portfolios that included only two securities:
Then, he added a third security to each portfolio:
And so on, and so forth.. until he realized that these portfolios, as more securities are added to them, they tended to fall onto what seemed like a curve.
This grey line is eventually known as the Efficient Frontier line. The efficient frontier is the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. It is represented by plotting the expected returns of a portfolio and the standard deviation of returns (aka: risks)
Markowitz, in his attempt to created a formula that allows an investor to mathematically trade off risk tolerance and reward expectations, created the Efficient Frontier line, where any point of the line gives the ideal portfolio for its risks and return levels.
This theory was based on two main concepts:
- Every investor’s goal is to maximize return for any level of risk
- Risk can be reduced by diversifying a portfolio through individual, unrelated securities
The efficient frontier is a curved line because every increase in risk results in a relatively smaller amount of returns. (recall we mentioned law of diminishing returns for higher diversification on your portfolio?) In other words, there is a diminishing marginal return to risk, and it results in a curvature.
A Practical Example
Hypothetical returns and factors are used in all my examples for educational purposes.
Say you'll only buy two stocks in equal weights: 50% in Singapore Airlines and 50% in Virgin Airways, in Portfolio A:
Singapore Airlines gives you a return of 5% while Virgin Airways gives a return of 10%.
The Weighted Average returns (aka Portfolio A's Returns) work out to be (and you don't need to know how to calculate this) 7.5%.
Because both stocks are in the same sector (Aviation), you're exposed to higher levels of systematic risks that could wipe out the entire aviation market (e.g: COVID-19).
If, instead of buying Virgin Airways with Singapore Airlines stocks, you bought Singapore Airlines and Tesla (with returns of 10%, same as Virgin Airways) in Portfolio B, you would get the same weighted average (portfolio returns) of 7.5% but a much lower risk, since Singapore Airlines and Tesla stocks don't share the same country or sector in which the business operates in.
As such, Portfolio B would have the same level of returns but lower risk compared to Portfolio A. On the graph, here is where portfolio A and portfolio B lie:
The efficient frontier is the foundation for modern portfolio theory, and it helps investors understand the potential risks and returns in their portfolios. It also helps investors analyze how they compare to optimal portfolios that are considered to be efficient, to be used as a benchmark for investing strategies.
It should be noted that there is no single efficient frontier and portfolio for everyone. Each one is different for every investor because it depends on multiple factors – such as the number of assets in the portfolio, the industry of the assets, and the degree of the investor’s risk tolerance. In financial planning for your future, your ideal portfolio also depends on numerous factors, such as affordability, risk appetite, and financial goals.
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