High levels of government debt, increasing inflation, heightened currency devaluation, widening credit spreads, and an overall collapsing economy… what could possibly go wrong?
Risk is all around us. Whether it’s driving to the office, hiking in the Rocky Mountains, running a marathon, or investing for retirement, risk comes in all shapes and sizes. Most of the time, it’s not only difficult to foresee sources of risk, but it’s also difficult to eliminate it as well.
Over their lifetime, an investor will be subject to constant changes in market prices, varying levels of volatility, black swan economic events, and changes in global macroeconomic policy. If one is not strategically positioned in their portfolio, or is simply unaware of their current risk exposure, such changes can have adverse effects on their savings and investments. Let’s start high level and look at portfolio risk.
A portfolio of public equities always consists of two major components of risk: (1) Idiosyncratic Risk, and (2) Systematic Risk.
Total Portfolio Risk = Systematic Risk + Idiosyncratic Risk
Idiosyncratic Risk
Idiosyncratic risk, or unsystematic risk, are risks associated to any single business regarding the structure of the company, its culture, investment strategy, financial policy, and its ability to continue operations. For an investor, this type of risk arises with a lack of diversification where an investor’s portfolio is limited to a small number of stocks or is too overweight in any one name or sector. Idiosyncratic risk can be reduced or limited through a diversified portfolio over many sectors of a particular index. Full diversification would essentially provide an investor with similar or equal returns to the overall index itself.
Systematic Risk
The risk remaining in this portfolio that can’t be diversified away from is simply the market risk, or systematic risk. This is the risk that any global index is subject to through changes in macroeconomic factors, interest rate policy, inflation, GDP growth, and other fiscal and monetary policies influenced by federal governments and central banks that can add volatility and uncertainty to short and long term trends in market prices. Changes in market trends can lead to “herd mentality” or what I like to call the FOMO of investing (Fear of Missing out on gains and losses, leading to buying and selling too late).
Figure 1 shows the relationship between the two types of risk and the number of stocks (let’s call it level of diversification) in one’s portfolio. As you can see, a level of systematic risk always exists regardless of how diversified a portfolio can be. As the number of stocks increases, the closer and closer the portfolio is to mimic returns of the overall market. Hence, as the number of stocks goes to infinity, idiosyncratic risk goes to zero, and the overall portfolio risk is just equal to the market risk.
Figure 1: Portfolio Risk vs. Number of Stocks in Portfolio
Source: Corporate Finance Institute
A study done in 1987 by Meir Statman called “How Many Stocks Make a Diversified Portfolio” looked at the average standard deviation of annual portfolio returns consisting of varying number of S&P500 stocks. Plotting the average standard deviation across many portfolios for a given number of holdings gives a chart similar to one in Figure 1, while also showing how much systematic risk there really is in the market. The conclusion from the study was to show the number of stocks in a portfolio that would give “optimal diversification”, or in other words, no more diversify oneself because the portfolio has essentially become the market.
Figure 2: Portfolio Standard Deviation vs. Number of Stocks in Portfolio
Source: Seeking Alpha
Figure 2 shows the same conclusion as Figure 1, where as the number of stocks in a portfolio goes to some very large number, the idiosyncratic risk (blue area) goes to zero, and the total portfolio risk is simply equal to the systematic risk (pink area). The study concludes that a maximum of 30 stocks is needed to be fully diversified. Any more stocks in a portfolio will give no added diversification to the investor. Of course, this conclusion assumes an investor is selecting profitable stable companies that span across many sectors, and not a bunch of penny stocks all in the health care space. It is of course very possible that any investor can achieve efficient diversification with having less than this “optimal” 30 stock count.
The chart also shows that no matter how diversified one is, a well diversified portfolio is always subject to the roughly 19.2% market standard deviation. To put it more simply, it is quite often that annual market returns can fluctuate within 19.2% on the up or down side of the average historical market annual return of 7%. Although this 19.2% standard deviation is specific to the S&P500, the conclusion from Figure 1 and Figure 2 can be applied to any indices.
Portfolios will consist of many stocks, bonds, mutual funds, ETFs, or likely some other type of exchange traded security. Of course, there are inherent risks associated with each one of these entities. Now that we’ve covered overall portfolio level risk, let’s dive deeper into risks associated with individual bonds, single companies, or entities that an investor will be putting money into to own. In addition to market risk, there are three primary types of risk that can affect investors:
Interest rate risk (or reinvestment risk)
This is essentially the risk associated to changing levels in interest rates. As noted in previous lessons, bond valuations move in opposite directions of interest rates. Therefore, if interest rates are increasing, one’s current bond holdings are decreasing in value. The reinvestment risk comes when bonds mature and an investor is left with a pile of cash to reinvest. Hence, reinvestment risk rears its ugly head when an investor is left in this position during a time of decreasing interest rates and is forced to reinvest their money in bonds that pay lower coupon rates.
Inflation Risk
This risk is associated with varying levels of inflation that can affect an investor’s purchasing power once a bond matures (or once a security is sold) and, once again, is left to decide where to reinvest their money. A high inflationary environment will limit an investor’s purchasing power or ability to purchase the same worth of bonds today as they have done in prior years (i.e. 1 dollar yesterday is worth less than 1 dollar today). This argument also applies to buying any publicly traded security or investment.
Credit Risk (or counterparty risk, or default risk)
Credit risk relates to the inability of a bond issuer or bond receiver to fulfill the contractual obligations to the other party (theoretically this isn’t limited to just bonds, but can include any transfer of funds to purchase an investment that involves two parties). If Cecil buys a bond from Bank A, there is credit risk associated with the bond issuer regarding the bank’s ability to purchase that bond back at par upon maturity, or to fulfill the regular bond coupon payments to Cecil. Bonds are rated by rating agencies to give an investor an idea of the likelihood of default on these bonds. Anything above BBB- is considered “investment grade”, while anything below BBB- is considered “junk bond” (a full list of bond grades can be found here). Typically, the higher the guaranteed rate of return of the bond, the more “riskier” it is deemed (this goes hand in hand with the idea that if something is too good to be true, chances are it is too good to be true). The inability of a bond issuer to fulfill its obligations to the bond receiver can lead to a bond defaulting, in which the receiver simply does not get paid or get their money back in full. Theoretically, a bond issuer faces counterparty risk in the event that the receiver does not return the bond security back. Although this doesn’t really happen at the retail level (i.e. you and me buying bonds), it can happen during bond exchanges between large financial institutions or during repurchase (repo) agreements where bonds are lent out for short periods of time (a few days) in exchange for cash that is borrowed at the repo rate (more on this in later posts).
A common mistake is for investors to underestimate their risk exposure, or to believe that investments like bonds are risk free, when in fact they are not. Consider the 3 types of equity and bond specific risks when deciding what securities to have in your portfolio for added diversification, as well overall portfolio risks when making decisions about your overall diversification. Understanding your own level of risk can give your portfolio a good “health check” on whether you are too invested in any one sector, or overly exposed to any one type of risk. If ever in doubt about the possible risks associated with bonds, ask someone who invested in Puerto Rican bonds 10 years ago whether they think bonds are “risk free”.
So to answer my question at the start of the post, “High levels of government debt, increasing inflation, heightened currency devaluation, widening credit spreads, and an overall collapsing economy… what could possibly go wrong?”
Well Figure 3 is what could go wrong. … bond par value is measured at 100.
Figure 3: Puerto Rican 25 Year Bond Valuations
Source: Zero hedge