Are you familiar with the universal rule of risk-reward?
The rule states that: High Risk = High Reward, Low Risk = Low Reward.
I’ll quickly explain, let’s compare a job and a business. Job is low risk because you will be getting the same paycheck every month even if you don’t work hard. The reward is also limited (paycheck). Business has high risk, there’s a good chance that the business won’t work. The reward here is high, if it does work then there is no limit on the amount of money you can make. The same goes for stocks, if you invest in small companies, you have high risk – high reward and the opposite with large companies.
But what if I told you there is a way you can get high reward with low risk. Does that ring a bell?
In this article, I will tell you how important diversification is while investing and also while trading. So let’s get on to it…
Understanding different kinds of risks
In stock markets there are two broad risks namely:
- Systematic risk: This is the risk affecting the entire market. A good example of systematic risk is interest rates. If interest rates go up, every company gets affected because the interest on the debt goes up.
- Unsystematic risk: This risk is specific to a company or an industry. For example the risk of a company losing a major lawsuit that erodes the future income generation prospects. This lawsuit would only affect that very company, not others.
If we buy one stock, it will have both systematic and unsystematic risk. But what if we buy and hold two stocks. What happens to the risk then?
Correlation of stocks
Before going ahead let’s understand correlation. Correlation is a statistic that measures the degree to which two securities move in relation to each other. If share A goes up by 1% and share B also goes up by 1% then we say they have a perfect positive correlation i.e. +1. If share A goes up by 1% and share B goes down by 1% then we say they have a perfect negative correlation i.e. -1. So correlation of two securities is always between +1 and -1 (0 meaning that there is no relation between the movement of two securities).
Now let’s have a look at the historical correlation between sectors observed in the past:
How Diversification can create a low risk – high reward portfolio.
IT (Information Technology) and Consumer Staples (FMCG) sectors have shown a low correlation in past. The reason is that IT boosts when GDP is growing fast and consumer staples grow at their own rate irrespective of the GDP.
Let’s say there are 2 shares TCS (Tata Consultancy Services), and Britannia, and let’s assume both have low correlation.
If we buy and hold the above 2 stocks together then the unsystematic risk goes significantly down (This is because if TCS goes down Britannia goes up, due to low correlation). The unsystematic risk goes down to such an extent that the total risk of holding both shares will be significantly lower than holding anyone share individually. This can also be proved using statistical formulas, but in this article I don’t want to go through them.
Btw do let me know in the comments below if you want a mathematical explanation of the concept
Now the risk went down, so logically the return should also go down by the same degree, right?
The answer is yes, the return does go down, but very slightly. The return takes a small hit but the risk goes down by a huge margin. Therefore, by buying these two shares we have lowered the risk significantly as compared to the reward, hence achieving low risk with higher reward.
Keep in mind lower the correlation, higher the risk reduced. If you buy TCS and Infosys then you wouldn’t benefit from the combination much. This is because they are in the same industry and have a very high correlation.
Please keep in mind that the exact opposite relation is literally impossible to find between 2 stocks, so we choose the stocks with minimum correlation
Awesome, then let’s diversify the hell out of our portfolio!
Easy there buddy, that’s not how it works. Overdiversification is another problem altogether.
When we go from 1 company in our portfolio to 2 companies, the risk gets reduced significantly. Then after that, each share we add reduces risk in a diminishing fashion. If we keep on adding shares ultimately the risk doesn’t change much but the return falls significantly.
Yes, the return starts falling. That’s why you’ll see successful investors investing 90% of their portfolio in less than 10 companies.
So there is a sweet spot which has to be achieved.
If you’re an investor, you have to have at least 3-5 shares in your portfolio, that too with low correlation.
Keep in mind not to sacrifice the quality of the shares just to have shares with low correlation
Don’t hold more than 15 shares in your long term portfolio. Also if you’re holding mutual funds then don’t buy 10 different mutual funds, you’ll be just hurting yourself that way. Never hold more than 3 mutual funds at any point in time. Also these mutual funds should be of different types, like small-cap, large-cap, sectoral, so that the correlation of those funds helps you reduce further risk.
If you’re a trader then the shares you are tracking should be from different industries. It should not be dominated by any one sector. This is a sure-shot way to reduce risk significantly.
“Never put all your eggs in one basket”.