Many investors are tempted to jump directly to stock selection when constructing a portfolio. But understanding and systematically managing risk is more important than choosing the “right” individual investments. And while risk cannot be completely avoided, it can be understood and constrained during the portfolio management process to improve the chances of success over time.
It is axiomatic that all investments carry a certain level of risk. Investors typically think in terms of the potential for suffering losses, but a literal definition of risk is the level of uncertainty or potential for deviation from expectations surrounding a particular investment selection. Some investment choices clearly involve substantial uncertainty, like a startup biotech company with an unproven treatment in clinical trials or the flood of new players in the promising but unpredictable cauldron of artificial intelligence. Some investors may be willing to shoulder considerable potential for losses in exchange for the possibility of large gains. This willingness to accept risk in pursuit of profits is at the core of capitalism and its attendant innovation.
For most individuals saving for retirement, the core of their investment plan should focus on the right balance among riskier opportunities with enticing but uncertain return potential and more stable investments with lower expected returns that are less likely to blow up. The process of spreading investment assets around different classes with varying degrees of risk is known as diversification and is arguably the first and most important element in constructing a portfolio.
Some investments are generally considered low-risk alternatives, like money market savings accounts or cash, offering limited long-term returns but a near zero risk of loss. But cash is not entirely riskless: inflation erodes purchasing power and acts very much like a loss over time. Until very recently, money markets did not keep up with inflation, and while currently offering positive inflation-adjusted returns, they are insufficient to provide sustained growth.
Moving up the spectrum, bonds offer slightly greater potential returns but introduce an additional element of risk, primarily from the fluctuation of interest rates. US Government bonds and bills are considered risk-free because their interest and face value are guaranteed by Uncle Sam but can fluctuate in price as the last two years have shown. Likewise, high-quality corporate bonds regain their face value at maturity and are unlikely to default, providing the portfolio an anchor to windward over time despite temporal fluctuations.
Common stocks supply more juice but a higher potential for loss. They are perceived as the sexier asset class at cocktail parties: everyone knows some guy who brags about buying Tesla at $20. That same dude never mentions his astute purchase of AMC at $560 (now worth $10). Yet over the longer term (10 years or more), stocks in general rise more than bonds despite sometimes significant crashes like those of 2000 and 2020. Most investors should hold at least some stocks to offset inflation risk and gain exposure to more growth while taking action to limit the volatility of equities.
It turns out that when Grandma said not to put all your eggs in one basket, she was expressing an enduring tenet of modern finance: diversification reduces overall risk. One can combine several investments with differing degrees of risk into a portfolio with lower aggregate uncertainty but still offering satisfactory potential for return. And it’s not that hard, and the number of individual securities need not run into the hundreds to accomplish the task, especially if one selects broad funds that encompass the disparate asset classes at a relatively low cost.
The magic of diversification depends upon the interaction of individual selections within a portfolio. Suppose you purchase shares of Ford Motor Company. As with all cyclical businesses, Ford’s fortunes rise and fall over time in response to factors like economic cycles and labor unrest. Adding another similar holding like General Motors does little to reduce overall risk, since the two stocks are highly correlated (they are similar companies and tend to move together). But adding a relatively uncorrelated stock like a pharmaceutical maker or a software company dilutes the potential negative impact from a decline in car sales or a spike in auto loan rates.
Using the principle of diversification, stock-level risk (called “idiosyncratic” or “stand-alone” risk) can be nearly eliminated through judicious selection of uncorrelated companies. At that point, the investor is left with the inherent risk attendant to being invested in stocks generally. This is known as “market” or “systematic” risk, and can best be visualized by considering the uncertainty in holding a broad market index fund, like the S&P 500. The fund suffers little damage if one stock blows up but is along for the entire ride if the whole market tanks.
Extending this concept a step further involves bringing in additional asset classes. Adding cash and bonds to a stock portfolio diversifies away some of the systematic risk of the broad stock market. Similarly, other classes like foreign stocks, small companies, real estate, and commodities, tend to further mitigate systematic risk when added to a portfolio even though some of these assets may have quite significant volatility when standing alone.
In the end, prudent management of investment portfolios involves much more than skillful stock picking. Research has consistently demonstrated that choosing individual securities is far less important than getting the overall asset class mix right in a broadly diversified portfolio that balances risk and return.