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I’m Ramon Cuenca, founder and director of Art and Finance, the website that makes learning Finance fun and accessible
So far in this series on Personal Finance, I’ve been coming back to a key principle of investing: the higher the reward, the higher the risk. So, what is risk, anyway?
Well, to be completely honest, as Oaktree Capital’s chairman Howard Marks once said, “much of risk is subjective, hidden, and unquantifiable.” While one of the bedrocks of mainstream finance theory essentially defines risk as volatility, for example the volatility of an asset’s price, this definition has been criticised, especially following the Global Financial Crisis of 2007-2009. Others offer an alternative view of risk, such as Warren Buffett, one of the most successful investors in history, who once basically defined risk as simply whether or not you earn a modest return on your investment.
Now, where does this leave us? Given the potential complexity we may encounter if we discuss volatility, let’s just keep things simple and follow Buffett’s definition of risk.
With that out of the way, let’s talk about risk diversification. As we know, risk increases as reward increases. In our previous video on the return objective, we learned that stocks generally provide higher returns, but higher risk, versus bonds. We also talked about a personal portfolio with 60% in stocks and 40% in bonds – a good combination of higher returns and lower risk for many individuals. This is an example of diversification – a technique where an investor invests in different financial assets to ideally increase overall return and decrease overall risk.
For example, let’s compare buying the stock of one company, versus buying that stock and those of nineteen other companies. Let’s say that one stock tanks, but the other nineteen do extremely well. In this case, diversification lowered risk AND increased return. The idea behind diversification is that you lessen the blow of risks specific to that one particular investment by spreading your money among different investments.
Obviously, the opposite case is also possible. What if that one stock shoots up 300% in one day? This is the argument against overdiversification: invest in too many things, and you lose out on returns specific to individual investments.
Depending on your own personality and circumstances, you can choose between varying degrees of diversification. One popular strategy, for example, is to hold 25-30 stocks for what studies have shown to be an optimal level of risk-reduction.
On the other hand, if you’re too busy to research on what stocks to buy, you can just buy the entire index, which Iris from our webcomic Ilusion describes as basically a portfolio of all stocks available within a certain geography or industry. For example, if you like US stocks but don’t want to pick any specific ones, you can always buy an index of US stocks, such an index that replicates the stocks listed on the New York Stock Exchange.
Diversification also extends beyond a single asset class. We’ve already talked about a portfolio of stocks and bonds, for instance. Beyond those are other asset classes, also known as alternative asset classes. These include hedge funds, private equity, real estate, and commodities. Generally speaking, these asset classes share the following attributes:
1. They are relatively illiquid, meaning they cannot be converted to cash easily;
2. A lot of due diligence is required to get an understanding of investments within these asset classes; and
3. Performance appraisal may be difficult as often you may not have a benchmark to which you can compare these assets
The upside is that these asset classes add diversifying potential to your portfolio, due to the fact that their performance may not be highly correlated to those of stocks and bonds. You could create what is known as a core-satellite portfolio, with traditional stocks and bonds forming a majority, or core, of your portfolio, and alternative asset classes forming a minority, or satellite, of your portfolio.
For your reference, we’ve drawn up a chart that explains the basic characteristics of each type of alternative investment, which you can find at our website, artandfinance.net.
Now that we’ve gone over risk and diversification, you should have an idea of how to set your risk objective. The risk objective is basically the amount of risk that you allow yourself to take, based on your willingness (which in turn based on your personality) AND your ability (which in turn is based on your circumstances) to take risk. It is important that you choose the more conservative of the two when determining your risk objective. Say you’re willing to invest in high-growth, high-risk stocks but need cash to pay off some personal debt over the near term. In this case, your ability to take risk takes precedent over your willingness to do so, and you should probably tilt your portfolio more towards bonds.
Notice that in setting a risk objective, we haven’t used any specific numbers. This is because, as we’ve discussed earlier, risk is subjective. Mainstream finance theory would use volatility as a measure to quantify risk, but that approach has been criticized. Therefore, to keep things simple, let’s keep our evaluation of risk qualitative, rather than quantitative.
We’ve now gone over the return and risk objectives, both of which represent the more theoretical aspects of Personal Finance. In our next video, coming out on 17 April, we’ll be talking about the more practical aspects, starting with the constraints to the Investment Policy Statement. See you then.
Ramon Rodrigo Cuenca, CFA
Art and Finance
Assistant: Mack Agbayani
CFA Curriculum Level III, volume 2, pp. 116-117
CFA Curriculum Level III, volume 5, pp. 7, 14-15, 28, 46-48, 76
Cunningham, Lawrence. The Essays of Warren Buffett: Lessons for Corporate America. p.92
Marks, Howard. The Most Important Thing. p.39
“Is Mainstream Finance Theory Adrift?”
Investopedia definition of diversification
“Investors Gravitate to Core/Satellite Portfolios”