When it comes to investing, we need to distinguish between two very different types of risk: good risk and bad risk.
Good risk is the type you are compensated for, in the form of greater expected returns. For example, shares are riskier than bonds, therefore over time, shares must compensate investors by providing greater expected returns.
The risk, of course, is that the expected does not occur. Similarly, the stocks of small-cap and value companies are riskier than their large-cap and growth counterparts. And just as the risk of owning equities cannot be diversified away, the risk of owning small-cap and value stocks cannot be diversified away.
Therefore, small and value stocks must also carry risk premiums.
In addition to the risk of owning shares and the risk of small and value stocks, there is a third type of equity risk—the risk of an individual company.
Consider the case of Enron, in one period named by Fortune as "America's Most Innovative Company" for six consecutive years. Its stock achieved a high of $90.75 per share in mid-2000 and then plummeted to less than $1 by the end of November 2001; it eventually declared bankruptcy.
Since this type of risk can easily be diversified away, the ownership of individual stocks is one that the market does not compensate investors for taking. Thus, it is bad (uncompensated) risk. And because investing in individual stocks involves taking uncompensated risk, it is more akin to speculating than investing.
The benefits of diversification are obvious and well known. Diversification can reduce the risk of underperformance. It can also reduce the volatility and dispersion of returns without reducing expected returns. A diversified portfolio, therefore, is considered to be both more efficient and more prudent than a concentrated portfolio of less than 15 stocks.
While individual stocks do offer the possibility of market-beating returns, they also offer the potential for disastrous results.
As you consider the potential outcomes individual stocks provide, keep in mind that investors are on average highly risk-averse, and the larger the amount involved, the more risk-averse they become. One reason for this is most individuals prioritise trying to avoid retiring (or dying) poor as opposed to retiring (or dying) rich.
Let's say you invest heavily in a New Zealand listed company. What difference will that investment make if the business doesn't find a way to create powerful international connections and crack open overseas markets?
New Zealand only accounts for 0.26 per cent of the world economy, but most New Zealand investor portfolios are overly weighted to our home market. In other words, a New Zealand investor with a strong home bias would have just a 7 per cent allocation to technology, compared to approximately 16 per cent in the global portfolios.
Pivoting to pharmaceuticals - which are topical of late - the figures are more extreme.
It's not that long ago that most mum and dad investors' experience with a diversified portfolio was a handful of Telecom, Telstra and GPG shares and for some with longer memories, Fletcher Challenge, Chase, IEP and Brierley. Many still hold bad memories from narrowly held investment portfolios from the 1980s.
Why might this be?
Given investors tend to source most of their income from their home nation and hold most of their other assets there, you can see that this degree of home bias represents a very big bet on one country, a couple of sectors and a handful of stocks.
So, the question then becomes what degree of home bias is acceptable. It shouldn't be surprising that there is no one right answer to that. It depends on each individual investor's tastes, preferences, circumstances and goals.
A good approach is to use a global market portfolio as your starting point. Suppose you want to increase the expected return of your portfolio. In that case, you can use information in current market prices and company fundamentals to tilt your portfolio towards stocks with higher expected returns. Research has shown that small caps, low-relative-price and high-profitability stocks deliver a premium over the market return.
While you may tilt your portfolio towards New Zealand due to your familiarity with the stocks, it's important to understand this has nothing to do with the expected return of your portfolio. It is just a preference. But it also comes at a cost.
In contrast, broad global diversification creates a portfolio that spreads its risk to more economies, a greater number of stocks, a wider range of companies and a wider spread of sectors.
"Finance is all about risk," as Nobel Laureate Robert C Merton highlights. Without risk, the expected return for an investor is simply the time value of money. The riskiness of the market changes every day. Why? Because companies generate risk through their daily activities. Most people can live with normal market variations but want to avoid catastrophic drops.
With this in mind, there are some inherent risks investors can reduce in a portfolio, namely holding only a few individual stocks or investing in only one country.
A financial adviser through careful and considered diversification, discipline and maintaining a level of flexibility, can help ensure that a single sector doesn't have a disproportionate influence on your investment outcome.
• Nick Stewart is a Financial Adviser and CEO at Stewart Group, a Hawke's Bay-based CEFEX certified financial planning and advisory firm. Stewart Group provides personal fiduciary services, Wealth Management, Risk Insurance & KiwiSaver solutions.
• This article is prepared in association with Stewart Partners, Australia. The information provided, or any opinions expressed in this article, are of a general nature only and should not be construed or relied on as a recommendation to invest in a financial product or class of financial products. You should seek financial advice specific to your circumstances from an Authorised Financial Adviser before making any financial decisions. A disclosure statement can be obtained free of charge by calling 0800 878 961 or visit our website, www.stewartgroup.co.nz