Portfolios: What Do the Academics Say?

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Portfolios: What Do the Academics Say?

While many stock investors question many aspects of Modern Portfolio Theory, they do believe it contains some important frameworks that may help you to feel comfortable when investing in a concentrated portfolio. One of them involves the two ways to define risk:

• Unsystematic risk is the unique risk of the company or stock that can be offset through diversification. Think of this as risk specific to a company, such as poor management, eroding profits, or a product recall.
• Systematic risk is the market risk that cannot be diversified. This is the risk that affects the valuation of all stocks

What the evidence says

Academics have proved that of your total risk, you can diversify away your unsystematic risk. The larger the number of stocks you own, the more diversified you are, and the less unsystematic risk that you incur. For instance, if the profits of one of your companies are falling below expectations, and if you hold a large number of stocks, chances are another company in your portfolio is exceeding expectations.

There is some risk that you can’t diversify away the systematic risk. You cannot eliminate the risk from the macroeconomic factors that affect all stocks. So even if you own 1,000 stocks, you will not diversify away the inherent risk of owning stocks.