The answer is diversity.
When it comes to the sharemarket, there are two types of risk; diversifiable (non-systemic) and undiversifiable (systemic) risk. Diversifiable risks are non-systemic in that they are inherent to a particular business or industry rather than the entire market. For example, an increase in the price of aviation fuel will impact the aviation industry heavily, but is unlikely to impact the price of locally grown beef. Moreover, it is likely to impact the rail and road transport industries in a positive fashion, with passenger and freight travel for each becoming more appealing as airline tickets rise. As you can see, a non-systemic risk can affect some shares positively, some negatively, and some not at all.
A systemic risk, such as a widespread national disaster or collapse of the market like the Global Financial Crisis (GFC) will impact almost all shares, generally in a negative fashion. As a result, no matter what shares you own, your returns will be affected.
So, how are your investments different from large-scale traders? By creating a varied portfolio, larger investors diversify away all of the diversifiable risk, which means anything short of a widespread collapse of the market will have almost no impact on their overall returns.
How many different shares do you need to reduce your diversifiable risk? It is generally accepted that a portfolio containing thirty different shares will achieve this, assuming that you don’t buy a large number of very similar shares (buying shares in thirty different mining companies for example). The volatility of your portfolio measures how susceptible it is to non-systemic risk, so a large number of similar shares will result in a more volatile (risky) portfolio. The correlation between particular shares measures how much they are impacted by a non-systemic risk.
With a diversified portfolio, your returns will be close to the risk premiums that companies are willing to pay to attract investors. The risk premium is a percentage amount more than the returns that investors can get from Treasury Bonds, which are basically a loan to the government. The returns are low, but payment is guaranteed. Without the risk premium, investors would simply invest in Treasury Bonds knowing they will get the return they have been promised. Historically in Australia, the risk premium is around 5-7%.
By choosing a slightly more volatile portfolio, you can hope to get higher returns, but be aware that there is the added risk that you may make a loss.
By Jennifer Lowe