Session 7. Deploy Risk Efficiently

One of the main pillars of the academic study of investing is efficient diversification. If two securities do not move together, owning some of both will produce an average return that is a straight-line interpolation between the two.  For example, the expected return of a portfolio half invested at 7% and half at 8% will be 7.5%.  But the risk of that bundle will be less than the same interpolation of the risks of the individual stocks!  This is the benefit of risk diversification.

There are strong diversification benefits from a combination of stocks and bonds, and even some material diversification benefits within the bond arena, but for simplicity of example we will discuss only stock diversification here.  In many portfolios, stocks are the main source of risk.  The best combination of expected risk and return typically results from portfolios with stocks of various types.  (For more detail ....)  For example, they would come from different industries, would include both rapidly-growing companies and those that were currently less successful, those that were large and those that were small, and include stocks of companies based in other countries.

The simplest analogy is with food groups.  Just as you may have been taught as a child to regularly eat some fruit, some green vegetables, some yellow vegetables, meat and fish, it is important for the investor to cultivate a taste for all kinds of different stocks.  It is also important not to eat too much of one thing.  Too much ice cream can make you sick.  Too much of one stock, even if it is the stock of the company that you are employed by or own, can unnecessarily increase your overall risk without improving your return.  This is a complicated subject, so that it is appropriate here to give a general rule as an approximation that may not apply in all cases but will keep you out of many serious troubles.  If you own individual stocks, try not to let any one stock be more than 10% of your portfolio.  Don't let 10 stocks be more than 50% of your portfolio.  These rules essentially imply at least twenty stocks, which starting out, you can only achieve through beginning with mutual funds composed of bundles of many different stocks.

Stock index mutual funds or their newer exchange-traded index fund (ETF) equivalents are an easy way to get ample diversification. They usually bundle hundreds of different stocks at very low administrative and trading fees.  For truly large portfolios, it is possible for tax and risk control purposes to do better with individual security holdings.  Very large portfolios have more complete ability to avoid unnecessary taxes and even in some cases to avoid the concentration on the most high-flying stocks that capitalization-weighted index funds employ.  But for most of us who are more interested in savings than investing as a blood sport, index mutual funds are the solid recommendation.

Quantitative approaches to true portfolio risk optimization are discussed in many finance texts.  Despite the attractiveness of an objective quantitative discipline, portfolio "optimization" is not something I would recommend for the typical "owner" or even for those interested in investing as an avocation.  Implementation can be dangerous even for the professional without long experience in working with quantitative methods in a practical setting.  There are too many pitfalls for the unwary.  The usual result is underestimation of risks because of statistical sample error and excessive trading costs as inputs change.  Instead, the second key concept of this session is that to easily improve the relation of return to risk, one should treat types of stocks like food groups -- buy some of each.  Do so even if you don't like the taste of some of the less-admired companies, industries and international flavors.  And start out with index funds.

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