By Dr. James M. Dahle, WCI Founder
The more I learn about investing, the more I realize it is about controlling risk and accepting the returns you get than it is about chasing the returns you want and accepting the risk you get.
It is a well-known general rule that you can't get high returns without taking on high risk. CDs simply don't have the expected return of microcap stocks. It is important that you take on enough risk to reach your goals by investing in assets that generate a significant real (after-inflation) return such as stocks, real estate, and small businesses. At the same time, you don't want to take on any more risk than you need to. If you receive a $5 Million inheritance from your rich aunt, you don't need to invest in the stock market, so you probably shouldn't, at least with any significant percentage of your portfolio.
Types of Investment Risk: Uncompensated and Compensated
However, there is a difference between compensated risks and uncompensated risks.
A compensated risk is a risk, which, if you take, will increase the expected (not guaranteed) return of your portfolio.
An uncompensated risk is a risk that doesn't increase, and may even decrease the expected return.
Diversify Against Investment Risk
Why would anyone ever take an uncompensated risk? Good question. The truth is, you shouldn't if you don't have to. Nobody does it knowingly. So how do you avoid it? Diversification. An uncompensated risk is a risk that you can diversify against.
Examples of Uncompensated Risk
#1 Investing in Single Stocks
For example, you can invest your portfolio all in IBM stock. Now, let's imagine IBM has about the same expected return as the overall stock market, say 5% real per year.
Now, is it more risky or less risky to invest in just IBM or to invest in all 6000+ stocks in the US market? Of course, it's a greater risk to invest in IBM. So shouldn't the expected return of investing just in IBM be higher? Nope, it doesn't work like that. Because you CAN diversify against that higher risk, you don't get paid to take that risk. You get paid for taking on market risk, but not to take on the higher risk of investing in a single company. If you were paid to take on that risk for every little company in the stock market, then the overall stock market return would, of necessity, have to be higher.
#2 Investing in Single Bonds
You can buy a bond from GM. If GM goes bankrupt and can't make the interest payments, or worse, even pay back your principal, you're screwed. Say the GM bond yields 6%. Are you better off buying 20 different bonds from 20 different companies all yielding 6% or just buying the GM bond yielding 6%? Of course, you want all 20. Same expected return, less risk.
#3 Other Examples of Unnecessarily Risky Investing
Other examples of uncompensated risk are buying a single investment property, or buying all your properties in one geographic area. Investing in actively managed mutual funds is also taking on uncompensated risk. You don't have to run the risk of manager underperformance because you can diversify against it through low-cost index fund investing to reach your financial goals.
We all know someone who put all his eggs in one basket and paid for it. It might be a grandparent who lost the farm, an uncle who lost his pension, his job, and his 401K all at once at Enron, or a colleague who got cleaned out investing 80% of his portfolio in Tech Stocks in the 2000-2002 bear market. Don't be that guy. Diversify your portfolio so you don't take on any uncompensated risks.
What do you think? Do you take on uncompensated risk? Why or why not? Comment below!