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Risk and return: how to strike the balance in your portfolio
Mike Deverell of Equilibrium Asset Management explains how finding the right level of diversification can reduce the riskiness of your portfolio.
Investing can be a risky business. Risk and return are highly correlated; the greater the return you want to make, the more risk you need to take to have a chance of getting it.
It is therefore vital that you understand what risks are inherent in any investment you make. Only once you understand the risks can you decide if the potential return is worth it. There is no point taking more risk than is required to meet a given return.
Risk and return: the theory
Say there are two stocks, company A and company B. Both are expected to return around 10% growth to investors. However, company A has a much more volatile share price than company B and a greater risk of loss. Given the choice, most investors would invest in company B, which offers similar upside but with less risk.
For an investor to buy company A, they would want to see a much greater potential return to justify the extra risk they are taking.
So what different types of risk do you need to take into account, and can you do anything to reduce your risk?
- Stock-specific risk: This is the risk inherent in an individual company. If you invested in just one stock, that individual company could underperform its peers (or even go bust) due to poor management, poor products, or just plain old bad luck.
- Sector-specific risk: This is the danger that an entire sector could underperform the market. For example, the UK banking sector has underperformed the FTSE over the past few years because of the financial crisis.
- Market risk: Both stock specific and sector risk can be diversified away by choosing enough different companies and sectors. You are then left with market risk, the risk that the market could fall. Remembering that risk and return are correlated, we could rename this 'market opportunity', the potential that the market will rise.
There is some debate as to how many positions are required to diversify away stock- or sector-specific risk. It is generally thought that at least 25 to 30 individual stocks are needed to diversify away most of the specific risk.
The simplest way of diversifying this away is to use funds, particularly index tracking funds.
Once you start looking overseas for opportunities, other risks come into play.
- Currency risk: Say you invest in Japan and your investment goes up by 10% in local currency terms. However, the Yen weakens by 15%. You’ve lost money, despite your apparently great stock picking! Some funds avoid this risk by currency hedging, but this increases the cost of investing.
- Geographic risk: Some countries by virtue of simple geography are riskier to invest in than others. Last year’s Japanese earthquake and tsunami is an obvious example of how an economy and a market can be affected by natural disaster.
- Political risk: This is the risk that government policy will have an adverse effect on your investment. This has historically been most prevalent in emerging market investing. For example, if you invest in China you would probably want an additional return compared to investing in the UK, due to the inherent political risk.
Unfortunately, political risk now seems to be unavoidable in any market and is currently the main driver of price movements of virtually all assets. As the eurozone debt crisis and the implications for our financial system continue, this seems unlikely to change soon.
Constructing a portfolio
To recap, risk and return are intrinsically linked, but some risks can be diversified away. By diversifying correctly, you can increase your potential return and reduce your risk.
As well as diversifying away specific risks in stocks, you can also diversify away some of the market risk of equities by investing in other asset classes, such as bonds and property. The asset allocation of a portfolio is the key driver of returns.
Getting the mix of a portfolio right is difficult. It is possible to overdiversify, as once you get past a certain point each additional position makes a much smaller difference to your risk.
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