Portfolio theory - Market risk management

According to the general portfolio theory, it is possible to remove the portion of the risk of a stock that is associated with uncertainty if the company performs as expected

This is the company risk and this risk can be eliminated by diversification

Studies shows that only about 20 shares in a portfolio largely eliminates the company risk. Then the portfolio will largely only be exposed to market risk

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Portfolio theory

Upturn after the crisis

Historical bubbles

Author: Johnny Guldager

Reducing the market risk

Also read about portfolio theory and the company risk

That it is possible to eliminate the company risk of your shares by diversification is due to the fact that the covariation and correlation of the individual company risk between different companies per definition is zero.

Market risk, however, is the type of risks that more or less affects different companies simultaneously. The extent to which the individual companies correlate with market risk, eg. in terms of risk of an index, will be different, but never zero. Therefore, market risk can never be fully eliminated by diversification. But by putting together a portfolio of companies that reacts differently to market risks, the portfolio returns and the overall risk can be optimized considerably.

How to calculate correlation and risk

By comparing the price movements of two different stocks, it is possible to calculate to which extent they move in the same direction when exposed to certain market conditions. Meaning to which extent they correlate.

It is actually pretty simple to place the stock quotes for the two companies in eg. an Excel sheet and use the standard functions of Excel to calculate the degree of covariation, ie. the correlation between the companies. The lower the degree of correlation between the companies is, the more you will reduce your exposure to the market risk.

It can be quite interesting in this way to calculate, how different combinations of stocks in your portfolio correlates differently with the market index and how your overall exposure to risk changes. Unfortunately these calculations for a large number of stocks will also be quite time consuming. So the question is, if there is a short cut.

You will get a long way with common sense

Most investors will feel they don't have the time or skills to perform all the necessary calculations and fortunately we can get really far with common sense. Companies that are very similar, eg. from the same industry, same size, same customer segment will have a tendency to be affected relatively equally by changes in the market. The strategy is therefore to select companies where you have expectations that will be affected differently.

If companies are in the same industry, you can benefit from choosing a larger company that operates on the broad mainstream market and supplement it with a small company that specializes in niche products in the same market. You can choose a company that is known for high quality products and combine with a company that sells discount versions of the same product segment. There is a good likelihood that these companies will correlate differently in relation to market risks and thus help optimize the overall relationship between return and risk in the portfolio.

Likewise, investments in different industries and sectors and for that matter, countries and regions will influence your sensitivity to market risks. Again, you can spend a long time calculating the theoretical values and adjusting the portfolio until the figures are optimal. But experience shows that common sense, when you spreads your investments, gives almost as good results.

It's all about being conscious of putting together a portfolio of shares, which we have reason to believe will be affected differently by changes in the market. This also implicates that you have to avoid the common mistake to fall in love with certain types of businesses, industries, large or small companies, value or growth.