Modern Portfolio Theory

and your portfolio management

Most investors are risk-averse. Those that are not often trade in options and are used to losing significant amounts of money. Because you read this you want to optimize or maximize your expected return while minimising your risk.

Individual stocks have 2 kinds of risk:

Market risk
or Systematic Risk or UNDIVERSIFIABLE risk
affects ALL stocks

Unique risk
or Unsystematic risk or DIVERSIFIABLE risk or specific risk or residual risk
affects individual stocks or small groups of stocks

Unique risk of different firms is unrelated and can be eliminated by diversification, that is what portfolio management does.

Market Risk

Market (systematic) risk can be explained by the following examples:
1) all firms are affected by the economy and exposed to market risk. The current global economic downturn clearly emphasized this.
2) we human beings need food, energy and other basic needs. The risk that commodity prices (e.g. corn, copper, crude oil) and/or implied volatility will change is a market risk.

Market risk cannot be diversified. Higher oil prices result in higher energy and gasoline prices which we must pay and which do reduce firms' profits.

Unique Risk

Unique (unsystematic) risk can be explained by the following examples:
1) a drug trial showing that beta blockers increase risk of cancer in older people will affect Pfizer's stock but has no affect on shares of GM or Danone
2) a strike at a single Siemens plant will affect only Siemens and perhaps its suppliers and competitors
3) a hot summer will increase demand for air conditioners but won't affect the demand for computers

Unique risks can be minimised by diversification.

Single stocks are exposed to both market risk and unique risk. But a good diversified portfolio is only exposed to market risk!

The major uncertainty is whether the market will rise or fall (and BST takes care of that risk!) but not whether one single company fails to deliver. The most benefits of diversification are achieved with 10 - 20 stocks in yout portfolio.

So portfolio risk in short:

the risk of a well-diversified portfolio depends only on the market risk

the risk of a non- diversified portfolio depends on both the market risk ánd the unique risk of the securities in the portfolio.

In order to reduce your risk and minimise your transaction costs we advise a portfolio of 12 to 17 stocks

For more information on modern portfolio management click here