Diversifying systematic risk (Theoretical perspective)

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Klausi123
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Diversifying systematic risk (Theoretical perspective)

Post by Klausi123 »

Hi guys,

my question is rather theoretical, but maybe someone can help me out here. So while reading a book, I came across the following statement:
By combining stocks into a portfolio, we reduce risk through diversification. Because the prices of the stocks do not move identically, some of the risk is averaged out into a portfolio. The amount of risk that is eliminated in a portfolio depends on the degree to which the stocks face common risks and their prices move together.
As to my understanding: (At least in financial theory) A stocks return moves up or down either because of firm-specific or market wide risk. Firm-specific risk is uncorrelated across companies and is averaged out, so diversified, in large portfolios. Some companies of my portfolio will experience good (firm-specific) news and some bad news. In the long run, good and bad news should average out in a large portfolio, leaving me with the systematic risk of my portfolio, which cannot be diversified.

However, why does it states that the amount of risk that is eliminated (or remains) depends on the degree to which my stocks face common, so systematic, risks? Wouldn’t this statement imply that I am able to get rid of systematic risk when I find two stocks whose returns are perfectly negatively correlated? Of course, finding those stocks in practice is impossible but here I am more interested in a theoretical consideration.
Consider an equally weighted two-stock portfolio. One stock has a ß of 1 and the other of -1.
From a theoretical point of view, my portfolio would face no systematic risk. Would this not also be considered a diversification of systematic risk?
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JoMoney
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Re: Diversifying systematic risk (Theoretical perspective)

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The author conflates "risk" with volatility, but would be correct in saying that the amount of volatility that can be 'diversified' away depends on the degree that the stock prices move together. If their movements are highly correlated, there is very little 'diversification benefit'.

Your example has 2 stocks where you explicitly state the prices do not move at all similarly/negatively correlated... So you're not disagreeing with the author, you're just giving an example of 2 stocks that are completely uncorrelated (which is not a real world scenario, just a theoretical example that does not dispute what the author said).
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firebirdparts
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Re: Diversifying systematic risk (Theoretical perspective)

Post by firebirdparts »

Klausi123 wrote: Wed Oct 14, 2020 8:09 am Wouldn’t this statement imply that I am able to get rid of systematic risk when I find two stocks whose returns are perfectly negatively correlated?
It's not an implication. These days, it's quite easy for retail investors to find instruments with perfectly negatively correlated returns, but you can't make money off them. If you are long and short the same position, you don't make any money. Returns are necessary for it to be interesting. for example, in 2 seconds you could have identified the two instruments with betas of 1 and -1: These are SPY and (for instance) SH. UPRO and SPXU make it 3 and -3. You can't make money from it.

You could entirely get rid of uncompensated or firm-specific risks. That should be possible.

I have no financial training, and I could be wrong about this: I think the ideal would be to have multiple investments with "high" expected returns and absolutely uncorrelated results. That is also not really possible, but you can judge real investments based on that idea.
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rkhusky
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Re: Diversifying systematic risk (Theoretical perspective)

Post by rkhusky »

Consider a sector fund with 200 stocks. It might seem diversified because it has a large number of stocks, but the stocks are all subject to risks specific to the sector.
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Ben Mathew
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Re: Diversifying systematic risk (Theoretical perspective)

Post by Ben Mathew »

Klausi123 wrote: Wed Oct 14, 2020 8:09 am Consider an equally weighted two-stock portfolio. One stock has a ß of 1 and the other of -1.
From a theoretical point of view, my portfolio would face no systematic risk. Would this not also be considered a diversification of systematic risk?
Yes, you will have diversified away your systematic risk. Beta = 0.

But the stock with beta -1 will be very expensive. It's expected return will be lower than bonds, possibly negative. So you end up with a portfolio that pays out the same as 100% bonds. (But with more risk if the stocks are not perfectly negatively correlated).

The theory doesn't say that you can't do this. Just that assets will be priced in such a way that you can't do it for free (i.e. without a reduction in expected return.)
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Klausi123
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Re: Diversifying systematic risk (Theoretical perspective)

Post by Klausi123 »

Ben Mathew wrote: Wed Oct 14, 2020 10:38 am
Klausi123 wrote: Wed Oct 14, 2020 8:09 am Consider an equally weighted two-stock portfolio. One stock has a ß of 1 and the other of -1.
From a theoretical point of view, my portfolio would face no systematic risk. Would this not also be considered a diversification of systematic risk?
Yes, you will have diversified away your systematic risk. Beta = 0.

But the stock with beta -1 will be very expensive. It's expected return will be lower than bonds, possibly negative. So you end up with a portfolio that pays out the same as 100% bonds. (But with more risk if the stocks are not perfectly negatively correlated).

The theory doesn't say that you can't do this. Just that assets will be priced in such a way that you can't do it for free (i.e. without a reduction in expected return.)
This is very helpful, thank you. I was actually wondering why the book never writes "diversify risk" with respect to systemtic risk but always describes it as "eliminate risk". As to my understanding, the term diversification is used to express that you can get the same return with lower variance. So a lower portfolio beta as described in my example indicates a low risk-adjusted return arising from a -1 and +1 beta. In other words, the portfolio variance may be reduce but same applies to the return. So the bottomline is, there is no reduction (in terms of diversification) on the overall systematic risk. It's just that I am willing to accept a lower return by having a low risk (variance) in my portfolio.
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Ben Mathew
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Re: Diversifying systematic risk (Theoretical perspective)

Post by Ben Mathew »

Klausi123 wrote: Wed Oct 14, 2020 1:58 pm
Ben Mathew wrote: Wed Oct 14, 2020 10:38 am
Klausi123 wrote: Wed Oct 14, 2020 8:09 am Consider an equally weighted two-stock portfolio. One stock has a ß of 1 and the other of -1.
From a theoretical point of view, my portfolio would face no systematic risk. Would this not also be considered a diversification of systematic risk?
Yes, you will have diversified away your systematic risk. Beta = 0.

But the stock with beta -1 will be very expensive. It's expected return will be lower than bonds, possibly negative. So you end up with a portfolio that pays out the same as 100% bonds. (But with more risk if the stocks are not perfectly negatively correlated).

The theory doesn't say that you can't do this. Just that assets will be priced in such a way that you can't do it for free (i.e. without a reduction in expected return.)
This is very helpful, thank you. I was actually wondering why the book never writes "diversify risk" with respect to systemtic risk but always describes it as "eliminate risk". As to my understanding, the term diversification is used to express that you can get the same return with lower variance. So a lower portfolio beta as described in my example indicates a low risk-adjusted return arising from a -1 and +1 beta. In other words, the portfolio variance may be reduce but same applies to the return. So the bottomline is, there is no reduction (in terms of diversification) on the overall systematic risk. It's just that I am willing to accept a lower return by having a low risk (variance) in my portfolio.
That's right. I used the term diversification to echo your wording in the OP, but it's not the right term for it. Diversification is when you can reduce risk without reducing return. So moving from the interior to the efficient frontier is diversification. Moving along the risk-return efficient frontier is not.
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Klausi123
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Re: Diversifying systematic risk (Theoretical perspective)

Post by Klausi123 »

Again, thank you very much. One last question: Isn't the systematic risk actually diversifiable when one has a portfolio which contains assets of many different geographical markets? The systematic/market risk refers to risks such as interest rate changes. Now if my portfolio contains assets from several regions (U.S., asia, africa etc.) shouldn't there be a diversification effect on overall systematic risk of my portfolio?
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JoMoney
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Re: Diversifying systematic risk (Theoretical perspective)

Post by JoMoney »

Klausi123 wrote: Fri Oct 16, 2020 4:52 am... if my portfolio contains assets from several regions (U.S., asia, africa etc.) shouldn't there be a diversification effect on overall systematic risk of my portfolio?
The "diversification effect" is highly dependent on the degree to which the stocks prices move together. If the stocks from several regions are highly correlated, there may be little to no "diversification effect", if they're more volatile and highly correlated it can lower "risk adjusted returns", and if the returns are worse it works against you both ways. ... In recent times, this is the real-world case.
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Ben Mathew
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Re: Diversifying systematic risk (Theoretical perspective)

Post by Ben Mathew »

Klausi123 wrote: Fri Oct 16, 2020 4:52 am Again, thank you very much. One last question: Isn't the systematic risk actually diversifiable when one has a portfolio which contains assets of many different geographical markets? The systematic/market risk refers to risks such as interest rate changes. Now if my portfolio contains assets from several regions (U.S., asia, africa etc.) shouldn't there be a diversification effect on overall systematic risk of my portfolio?
No. The diversification you get from investing in different geographical markets is not conceptually different from the diversification you get from investing in different firms or sectors in the same country. Systematic risk is what is left when you have diversified away all of those risks and have gotten to the efficient frontier. It includes interest rate changes, but will also include other things like a global recession. Even if you've diversified as much as possible, you don't know your exact return (unless you're 100% safe bonds). That risk that's left over is systematic.
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Klausi123
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Re: Diversifying systematic risk (Theoretical perspective)

Post by Klausi123 »

So when we talk about market risk, do we consider the term market to refer to a global market? I understand that the risk of a global recession is not diversifiable because it affects all regions. In the case of the market risk arising from a change in interest rates, I still try to wrap my head about it. Interest rate changes are likely to affect individual regions (depending on the region). So I may diversify the risk of an interest rate change by investing in regions where interest rate decisions are not so dependent on each other (US and Africa, for example). Or do I need to view the market in "market risk" not as individual markets in a region but as a global market, so we refer to interest rate changes to those who affect the global economy?
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Re: Diversifying systematic risk (Theoretical perspective)

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Klausi123 wrote: Sun Oct 18, 2020 2:57 am So when we talk about market risk, do we consider the term market to refer to a global market?
Theoretically, yes. But most tested/proven empirical models don't use global market as the market factor.
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Re: Diversifying systematic risk (Theoretical perspective)

Post by Ben Mathew »

Klausi123 wrote: Sun Oct 18, 2020 2:57 am So when we talk about market risk, do we consider the term market to refer to a global market? I understand that the risk of a global recession is not diversifiable because it affects all regions. In the case of the market risk arising from a change in interest rates, I still try to wrap my head about it. Interest rate changes are likely to affect individual regions (depending on the region). So I may diversify the risk of an interest rate change by investing in regions where interest rate decisions are not so dependent on each other (US and Africa, for example). Or do I need to view the market in "market risk" not as individual markets in a region but as a global market, so we refer to interest rate changes to those who affect the global economy?
Yes, the "market" here refers to the market for all investable assets--so it's the global market, not a local market. So "market risk" means undiversifiable global market risk.
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Re: Diversifying systematic risk (Theoretical perspective)

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firebirdparts wrote: Wed Oct 14, 2020 8:37 am
I have no financial training, and I could be wrong about this: I think the ideal would be to have multiple investments with "high" expected returns and absolutely uncorrelated results. That is also not really possible, but you can judge real investments based on that idea.
This is the idea behind "slice and dice" investing which involves adding such things as Small-Cap Value, Micro-Caps, International Small-Cap, and REITs to a portfolio. Problem is that in a crisis "non-correlating" assets tend to correlate, and correlate on the way down. Also correlations between asset classes change over time. The markets are dynamic. What non-correlates today may correlate tomorrow.
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Klausi123
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Re: Diversifying systematic risk (Theoretical perspective)

Post by Klausi123 »

Thanks for your help with my questions. Really appreciate it :happy
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