Tuesday , 5 December 2023

Understanding Systematic Risk, Modern Portfolio Theory and the Efficient Frontier (4K Views)

Risk inherent to the entire market or market segment is referred to as systematic risk and modern portfolio theory says that a blend of investments has the potential to increase overall return for a given level of risk, and/or decrease risk for a given return that the investor is trying to achieve. The expected risk/return relationship is known as the efficient frontier. [If you have a portfolio of investments then you need to fully understand what all this really means and how you can apply it to your portfolio makeup to enhance returns under any circumstances. Let me do just that.] Words: 1325

So says Alan Johnson (www.thereasonedinvestor.wordpress.com) in edited excerpts from his original article* which Lorimer Wilson, editor of www.munKNEE.com has further edited below for length and clarity – see Editor’s Note at the bottom of the page. This paragraph must be included in any article re-posting to avoid copyright infringement.

Johnson goes on to say, in part:

There are 2 kinds of risk – non-systematic and systematic.

Non-systematic Risk

In an earlier post I discussed the use of diversification as a means to mitigate non-systematic risk (i.e., risk that is unique to a specific company).

If, for example, you happen to be bullish on oil, investing in a fund that holds a variety of oil company stocks greatly reduces the severity of decline in your portfolio if one of the companies experiences an Exxon Valdez or BP Deepwater Horizon event. So diversification involves taking somewhat smaller positions in several companies that participate in similar markets.

Systematic Risk

Let’s now imagine that a major university reports that researchers have discovered a means by which zero point energy-based power generation systems can be commercialized, and with it the potential for electricity that is truly “too cheap to meter.” In this scenario, the stock prices of all oil companies in your fund, and thus the price of your fund itself, would plummet. This is an illustration of systematic risk, which is the risk inherent to the entire market or market segment.

It follows, therefore, that systematic risk can be mitigated by allocating one’s investments across various funds that represent dissimilar markets or segments. In portfolio theory, such dissimilarity is measured using a mathematical term known as correlation (which we’ll get into later).

A Simplified Illustration of Modern Portfolio Theory

Aside from mitigating risk, allocation has another advantage. This advantage is often illustrated conceptually using small business metaphors. For example:

  • consider a landscaping business in the northeastern U.S. where I live. Profits are high in the spring and summer, dwindle somewhat in the autumn, and are practically non-existent in the winter. On a monthly basis, the ‘returns’ of this business would be highly volatile (albeit predictable). Let’s imagine profits of $10,000 a month for this small business from April through August; $5,000 a month from September through December; and $0 per month from December through March. Over one year our imaginary landscape business has generated $70,000 in profits. The monthly profits over the year range from a high of $10,000 to a low of $0.
  • Our small landscaper has a couple of heavy-duty pick-up trucks for hauling equipment and supplies to the various job sites. Why not make a small additional investment in snow plow attachments and use these trucks to clear snow from driveways and parking lots during the winter months? Given the vagaries of the weather, let’s say that our landscaper now earns an additional $20,000 over the 4 months from December through March in his snow removal business. The monthly high of $10,000 and low of $0 may be unchanged, but the number of months in which profits are zero has decreased.

Two things have happened:

  1. Annual profit (or ‘return’) has increased from $70,000 to $90,000.
  2. Because some income is now coming into the business over the winter months, the monthly fluctuation in profits (‘volatility’) has been reduced.

So we see in this simple thought experiment that allocation has the potential to both increase returns and reduce volatility in a business and, by extension, an investment portfolio.

Understanding Modern Portfolio Theory as an Investment Concept

Our thought experiment [above] is a simplified illustration of a more complex investment concept known as modern portfolio theory. Let me try to walk you through this using the diagram below:

It starts with the simple premise that an investor logically expects to receive a ‘reward’ (i.e., return) that is commensurate with the risk he or she is taking in making the investment. In our diagram:

  • Investment A has relatively low risk (as measured by the volatility, or extent of price fluctuation over time) but also has a relatively low annual return. Typically, a bond fund or some other type of fixed income investment would have these characteristics.
  • Investment B, on the other hand, might be a stock or equity fund that has a higher expected return but carries a higher degree of risk as well.
  • An investor willing to ‘split the difference’ in terms of risk in his/her portfolio might expect that holding 50% of A and 50% of B might result in a combination of risk and return midway between that of A and B as shown by point C on the diagram.
  • Modern portfolio theory, however, says that assuming risk midway between that of A and B by blending the two investments in one’s portfolio will, in actuality, generate a higher return equivalent to point D.
  • Moreover, point D is not the return one would receive in a portfolio consisting of a 50/50 mix of A and B. Instead, a 50/50 blend of A and B would result in a return equivalent to the average return of both investments, but at a much lower risk (degree of portfolio’s fluctuation in value) equivalent to point E on the diagram.

As such, modern portfolio theory says that a blend of investments has the potential to increase overall return for a given level of risk, and/or decrease risk for a given return that the investor is trying to achieve.

The Efficient Frontier

The blue curved line defining the expected risk/return relationship is known as the efficient frontier. Notice that, in moving from point A to point E by increasing the holdings of Investment B, a significant additional return has been received with only a small amount of additional risk but, as more risk is assumed beyond that point, the benefit in terms of additional return becomes smaller and smaller.

If you do a Google search on images for ‘efficient frontier’ you’ll find all sorts of complicated and interesting curves, with all of them having a convex shape to some degree and this convexity, illustrates what is sometimes referred to as the ‘free lunch’ of investing (the extent of which is shown by the green arrow in our diagram above).

The specific shape of the efficient frontier curve is influenced by such things as:

  1. the number of holdings in the portfolio,
  2. the risk/return characteristics of each holding, and
  3. the extent to which the returns of each holding are correlated with the returns of the other holdings.

The Takeaway

  1. Systematic risk is the risk inherent to an entire market or market segment.
  2. Asset allocation can mitigate systematic risk and has the potential to both increase returns and reduce volatility in an investment portfolio.
  3. This is due to an aspect of modern portfolio theory which demonstrates that a blend of investments has the potential to either increase overall return for a given level of risk, or decrease risk for a given level of return that an investor is trying to achieve.
  4. These advantages are influenced by such things as the number of holdings in the portfolio, the risk/return characteristics of each holding, and the extent to which the returns of each holding are correlated with the returns of the other holdings.

The correlation aspect is one of the trickiest to manage. The idea is to select an appropriate number of asset classes with valuations that, while generally increasing, are not expected to move in precise tandem with each other over the investment holding period.

*https://thereasonedinvestor.wordpress.com/2010/08/15/using-asset-allocation-to-reduce-systematic-risk/  (To access the original article please copy the URL and paste it into your browser.)

Editor’s Note: The above article has been has edited ([ ]), abridged (…), and reformatted (including the title, some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. The article’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article.

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