Portfolio, Diversification and (Un)Systematic Risks

We wrote about unsystematic risks and are desirous of resolving these risks. Why is it important to do so?.... Simply because these risks can be eliminated through diversification. Unintended risk is the bug bear in our search of making superior return on a risk-adjusted basis. What we want is the systematic risk embedded to a particular value proposition ( grouping ).

The more homogenous the grouping is, the clearer would be the signal in highlighting risk associated to that grouping. This can be achieved by tracking its beta.

It will require a mind set change to uplift the performance within that grouping, and would usually require extra-forces to kick in the change. Its alpha will be lifted when this is achieved, implying a superior performance on a risk-adjusted basis. As such, the baseline is for securities to be priced according to their respective systematic risks.

We should not take more risks than necessary in seeking superior return. Otherwise, we will continuously be short-changed. This will be the quickest way to lose our competitive edge.

First, let us identify some instances of unsystematic risks.

Take the case of a rogue trader who managed to circumvent all the checks and balances and raked up enormous losses. What happens to the share price ? - goes through the floor. An exception rather than a rule ? Perhaps not....perhaps it is a "black swan"

Nassim Taleb defines ‘black swan events’ in the following way:

A black swan is an outlier, an event that lies beyond the realm of normal expectations. Most people expect all swans to be white because that's what their experience tells them; a black swan is by definition a surprise.

Take another instance, accounting irregularities via off balance sheet transactions. Stock price got smacked and again lower ( or no ) return for higher than expected risk.

Well, we got it. It is all about trust. And trusting your fellow beings are much more difficult than we realise.

We can erect all the fanciful controls but we end up with a seize mentality which is not conducive for collaboration.

If we build a framework around risks, we may be able to slowly get an idea on how we can eliminate unsystematic risks.

Let us adopt the top-down approach i.e. market - industry - entity specific.

The higher the level, the more difficult it is to game the system. Or rather, signals allow us to track trends better and able to also predict the responses by the market. It is easier to read the market as oppose to industry, and for sure easier to read industry as oppose to corporates.

So the following serves as the framework for taking ownership of the resolutions for the new year.

What Counts

If the past is some guide, we should be able to say with some degree of certainty that we can average an annual return over a longer time horizon, and also the volatility that goes with it. And when we place two asset classes together, we are also able to discern how well these are correlated and extrapolate the relationship into the future. By blending two asset classes with low correlation coefficient, we may be able to optimise return while reducing risk.

This may be counter-intuitive, but it can be worked out mathematically.

Some other observations. Be prepared to invest larger quantum in order to derive a decent income. $100,000 at 8% will yield $8,000 while $10,000 will only yield $800.

If you allow for compounding effect, after 5 years $100,000 of capital will yield $46,933 of profits and after 10 years it will be $115,892 of profits.

Use the concept of quality to define your financial milestones

So if you review your surplus funds and figure out that you are unlikely to draw down the surlpus funds, you can begin to shift these to other appropriate asset classes. The idea is to be an ACE investor i.e. ability to articulate, communicate and execute on pre-agreed milestones. You may like to achieve this by leveraging on three critical success factors i.e. mastering of domain knowledge, technology and networking.

The key is to master the ability to optimise return against return. Sharpe ratio comes in handily....

Develop a gantt chart to track your progress

You need to commit to a timeline in developing a financial model capable of generating efficient portfolio comprising various asset classes. With such a model, you would be able to short-list portfolios that fit into what you deem as value ( quality ) investing.


Act forthwith

Allocate resources to invest in the selected portfolios. Track the performance of the selected portfolios, ever mindful of the need to fine-tune as you move along.

It is essential that we act on what we set out to do. Only then would we be able to stress test our value proposition. When we act, we are doing the walk the walk routine, and this allows us to cover every aspects of the processes. If any of these falls short, we will learn very quickly as we will end up hodilng the losses.

Tom Peter's quote could not be more apt:

"The winners stun us not by their cleverness, but by the fact that every tiny aspect of the business is just a touch better than the norm."

By actioning, we will uncover gaps. From these gaps, we will draw lessons and improve on the processes. By learning and developing, we sharpen the focus and sooner rather than later, we will be able to acieve our key milestones.

The next task will be to maintain an inventory of gaps, priortise and work through the items.

We should then be able to create a virtuous cycle via a process of positive reinforcements.


Connect


Rope in family members, friends, business associates and have them involved. By serving as a catalyst, you will soon create a hub-and-spoke platform thus facilitating proactive collaboration. In this way you can impart knowledge and eventually this will lead to a depository of knowledge to be shared and developing win-win scenarios. As participants take ownership, a viable value proposition will emerge.


Keywords: quality, value systems,
trust, domain knowledge, technology, networking, maven traps, speed of trust, lifestyle

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