The direction of the market is heavily influenced by people as individual investors. As long as some investors have not folded their hands or gone all in, the market still has upward potential – simple but true. The rally may not be over yet, but the market continues to flirt with new highs, leaving investors on high alert.
The fact is that all three major indices, The S&P 500, The NASDAQ Composite, and The Dow Jones Industrial Average, have seen stronger growth since 2008. Overall adjusted market earnings are up as much as 7%. Earnings continue to break out, leading to higher stock prices. As long as earnings continue to grow, investors will continue to get in on the market. When earnings fundamentals change direction, and start to consistently move downward, a market correction may not be far off. At the moment, every indication points to gradual growth with slow rising interest rates, which I consider to be healthy for the economy. As long as earnings fundamentals are moving in the right direction, we are okay; however, play on the side of caution and prepare your portfolio to weather the storm.
Exhibit 1. 10-Year Return of all Three Major Indices
The S&P 500 index includes 500 leading large-cap U.S. companies, covering 75% of U.S. equities.
The NASDAQ Composite Index is comprised of more than 3,000 listed U.S. companies.
The Dow Jones Industrial Average contains 30 component companies in various U.S. industries.
How should you plan ahead and capitalize on either side of the market? One easy way to play either side of the market is to invest in a variety of securities that you think still have growth potential, but hedge against them in case you are wrong. You can hedge using options strategies, or simply by diversifying your portfolio. In this article, we will focus on hedging by diversifying your portfolio, and understanding the relationship between risk and return.
It is important to note that risk is the degree of uncertainty about your expected return from an investment, including the possibility that some or all of your investment may be lost. Risk also entails the possibility that an investment may go down in value or not perform as well as expected. No investment, whether domestic or international, is risk-free. Even money lying securely in a savings account may be at risk of inflation. One fundamental rule that applies to all investments is that the smaller the risk, the smaller the potential return. Conversely, the higher the risk, the higher the potential return. Higher-risk assets are generally priced lower to offer the potential for higher expected returns than lower-risk assets.
The total risk of a portfolio consists of two parts:
1) Systematic (or market) risk
2) Unsystematic (or firm-specific) risk
Total risk = systematic risk + unsystematic risk
Systematic risk influences a large number of assets and is also referred to as market risk.
Unsystematic risk influences a single company or a small group of companies, and is also called firm-specific risk or unique risk.
A high proportion of risk faced by an individual company can be attributed to its activity, management, and more. As such, a large extent of unsystematic risk can be eliminated by diversification. Put in a different way, a portfolio with a wide assortment of stocks may have almost no unsystematic risk. Systematic, or market risk, that businesses face will threaten nearly every company. This risk cannot be avoided, regardless of the degree of diversification. Thus, systematic risk can be considered non-diversifiable risk. The reward for bearing risk depends only on the systematic risk of an investment – no matter how much total risk an asset has, only the systematic portion is relevant in determining the expected return (and the risk premium) on that asset.
Below is an example of probable outcomes when hedging through diversification.
Exhibit 2. Expected Rate of Return