Unique Risk Series – Article 3 out of 3
In the first two articles of the Unique Risk series, we explored some interesting portfolio theory but didn’t discuss any practical application of the theory. In this, the final article of the Unique Risk series, we will bring together everything discussed so far and describe how the ideas can be applied to your investments.
As you recall, the examples used in the first two articles were based on a two-asset portfolio. As we already discussed, a two-asset portfolio still carries with it a great deal of unique risk that should be diversified away.
As the above graph from the first article illustrates, adding more assets to your portfolio decreases the unique risk of your portfolio.
So what is the best way to diversify your portfolio to eliminate unique risk completely?
Let’s create a graph, similar to the graph we made in the previous article, but instead of the graph only representing a two-asset portfolio, let’s graph portfolios containing all of the stocks in the market. Just as with the two-asset portfolio, there are combinations of assets that are more efficient than others.
The dots represent portfolios that aren’t efficient and the curved line represents the efficient portfolios. Remember, an efficient portfolio is one whose expected return can’t increase without also increasing the standard deviation of the portfolio.
Let’s also assume, as we did in the previous article, that there is a risk-free asset available to investors that allows lending and borrowing at the risk-free rate (this is labeled rf on the graph).
As was described in the previous article, it is better to invest in the efficient portfolio that is tangent to the risk-free rate line and then lend or borrow at the risk-free rate than it is to invest in a different efficient portfolio or a non-efficient portfolio.
It turns out, the point of tangency between the risk-free line and the efficient portfolio frontier of all available assets, labeled m in the graph above, is actually the market portfolio (i.e. the weighted average of all the assets in the market)!
Therefore, what the theory concludes is that investors should invest in the market portfolio and then lend or borrow at the risk-free rate in order to obtain the highest expected return with the desired level of risk exposure.
By investing in every stock in the market, you are able to eliminate unique risk, thus leaving yourself exposed only to market risk!
Market portfolio. Risk-free asset. Aren’t these all just theoretical ideas? Yes, but there are close analogs in the real investing world.
The easiest way to invest in the market portfolio is not to go out and buy every stock in the market. Companies like Vanguard have already done the hard work for you and offer total stock market index funds to invest in. The even better news is, they actually charge very low fees for this service so you get the benefits of diversification without having to pay a lot of money in management or transaction fees!
How about the risk-free asset? While the risk-free asset is just a theoretical financial instrument, there are risk-almost-free assets that come close. Short-term US Treasuries, for example, are probably the closest analog to a risk-free asset, since they are backed by the US government and carry very little risk of default.
So to wrap up this series, in the first article we learned why diversification can be beneficial. When diversifying, you can decrease the amount of unique risk your portfolio is exposed to while potentially increasing your expected returns.
In the second article, we investigated how different ratios of assets are better than others and described why it is better to invest in efficient portfolios and then use the risk-free asset to adjust portfolio risk to desired levels, rather than investing in non-efficient portfolios.
Finally, in the last article of the series, we discussed how the market portfolio is the ideal efficient portfolio to invest in because it eliminates unique risk and allows you to use the risk-free asset to adjust your risk exposure to desired levels.
In order to keep this series (somewhat) concise, I wasn’t able to fully explain some of the theory behind these ideas. If you are interested, you should read more about the Capital Asset Pricing Model (a.k.a. the CAPM) to really get your hands dirty.
To learn more about the benefits of investing in index funds, particularly those offered by Vanguard, check out the following articles:
There are many benefits to this approach so I will likely come back to this topic to explain some of the other benefits in the future but I thought focusing on unique risk was a good starting point because it was a good excuse to geek out with some math, graphs, and financial theory!
I must mention, I’m not a professional financial advisor so, as always, please do your own due diligence before making any investment decisions.
If I left anything out or if you have any questions, feel free to ask in the comments below!
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