Risk?
I’m in the middle of reading a book on Financial Statement Analysis and the authors have decided to take a moment to define “investment theory and financial statement analysis”.
The book leaped right into the debate by defining the beta coefficient theory as, “total risk associated with an investment is comprised of two elements: systematic risk, the risk attributed to prevailing market movements, and unsystematic risk, the risk unique to a specific security.”
We all know where this leads us – right down the path of referring to beta as the definition of systematic risk. Where a security with a beta of 1 moves perfectly in line with that of the “market” and a security with a beta of 1.5 moves 50% more than the market (for example if the “market” was UP by 1% in a given day then a security with a beta of 1.5 would be up 1.5% on that given day and on a day when the “market” was DOWN 1% this security would be down by 1.5%).
The theory says that you want to hold a diversified portfolio to eliminate unsystematic risk away (remember that this is the risk unique to a specific security). In other words, you don’t know the next company that has a “BP oil spill” type of event so by holding a bunch of companies in your portfolio you reduce the impact that this type of thing would have on your overall net worth.
For many investors, this is the absolute right thing to do. Hold a diversified portfolio because you don’t have the time to do the research necessary to hold just a few select companies. However, for those investors who are interested in spending the time necessary to research companies I would argue that you want to hold as few securities as possible to try to eliminate ‘systematic risk’.
If you know your companies inside and out, why do you want to deal with “market risk”. You want to eliminate “market risk” because it is erratic and unpredictable. If you have good knowledge of your companies, then you know the risk that are involved and are willing to accept them because you believe, based on your due diligence, that the management team is able to deal with them. Diversifying to the point that you have market risk means that you have now introduced an unknown risk to your portfolio – something that you can’t control.
This is what I want in my portfolio of individual stocks – less systematic risk and more unsystematic risk. I want to be rewarded or penalized for my hard work so I will continue to own very few stocks in my portfolio.
Bissett's Thoughts 
This is a good explanation of systematic and unsystematic risk. The current market conditions have showed huge swings in systematic risk because of financial concerns for example of the health’s of Bank’s and sovereign debt of European countries. I’m using professional Portfolio Analysis software to minimise such risk. How effective would you say this approach can be?
That’s a good question. I’m not sure about statpro.com as a source. It’s not something that I have taken the time to research. My question is what does it provide. My concern as an individual investor is whether or not portfolio analytics can do you any good.
At the end of the day, are Goldman Sachs, Morgan Stanley, Merrill Lynch and the other major players in the market over-manipulating the short and intermediate nature of the market for their own advantage and to your detriment? How many times have you been “shaken out” of a position because of the “market action” and not because of your own internal decision making.
If you are buying individual securities that you know inside and out, then you can ride out the short and intermediate term nature of the market. I guess my question is do you have a process that you can follow (with or without the assistance of statpro.com) regardless of the market noise? Even if you are an ‘economic investor’ and you have a system that you can invest by, then you can avoid getting shaken out for dumb reasons.
I will expand on my thoughts over the weekend.