April 23, 2010
Life can be less risky overall if you strive to keep your human capital and financial capital uncorrelated, particularly for those subject to the boom and bust cycles of the Silicon Valley. Whether your human capital is equity- or bond-like, it is important to eliminate risks that can be easily eliminated.
Many people invest in what they know. In the Silicon Valley, it is technology stocks. If you invest your capital into just a few promising publicly-traded tech companies and just one goes bankrupt, the loss can be irrecoverable. This is called “unsystematic” or company-specific risk.
There is power in numbers, however, as unsystematic risk can be eliminated through diversification, one of the three key investment principles. Some say unsystematic risk can be diversified away with as few as 30 stocks. “Systematic” or market risk, however, cannot be diversified away. Entire publicly traded securities markets can be affected by changes in interest rates or the economy in general.
Since the advent of Modern Portfolio Theory in the 1950s, investors began measuring risk in terms of standard deviation, a statistical measure of variability around the historical average. All priced investments with enough history can be measured in this way.
Let’s say an investment has a 5-year annual average return of 8 percent and an annualized standard deviation of 10 percent. This means two-thirds of its historical returns have fallen between -2 and 18 percent (one standard deviation), and 95 percent have fallen between -12 and 28 percent (two standard deviations). A statistician would say you can be 95 percent confident that your future annual returns will fall between -12 and 28 percent. Of course, there is a 5 percent probability of exceeding two standard deviations on either side of the average.
One weakness of standard deviation is that it is a historical measure of variability, and there is certainly no assurance that history will repeat itself. The measure assumes that returns are “normally” distributed or have fallen just about equally on either side of the mean return. Returns distributions, however, can be “skewed” either negatively or positively, and negative “skewness” in particular is not good. Who wants an investment with more negative than positive surprises?
Eliminating unsystematic risk does not guarantee elimination of losses. Selling a diversified portfolio at the bottom of a bear market realizes losses. However, if you eliminate risks easily eliminated, long term success becomes more of a behavioral challenge than anything else.
