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 which doesn’t increase, and may even decrease the expected return. 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.
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 is more risky 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 risk, you don’t get paid to take that risk. You get paid for taking on market risk, but not to take on the 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.
Another example: You can buy a bond from GM. If GM goes bankrupt and can’t make the interest payments, or worse, even pay back your principle, 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.
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 funds.
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!