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Risk II; Systemic Risk September 30, 2008

Posted by shaferfinancial in Uncategorized.
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Following up on our discussion of strategic risk yesterday, we will discuss systemic risk today.

Systemic risk makes up the majority of what most investment folks consider risk. Very simply it is variance. It is the total margin, both positive and negative, of the possible rates of return. For a stock the possible negative is -100% or total loss of all capital and the possible positive is infinity.  A stock can go up as high as its cash flow allows it.  In more practical terms the total possible can be thought to be +500,000% (Berkshire Hathaway has gone up 400,863% in the last 43 years). So we can reasonably say that any stock has a variance of 500,100% (500,000% + 100%)!

Now we see why mathematicians think that any single stock is tremendously risky! Now as a way to deal with this risk, most investment professionals suggest diversification. What diversification does is truncate the possible rates of returns. For example, if you own 20 stocks it is highly unlikely that all 20 will go out of business. It is also highly unlikely that all twenty will return anywhere near what Berkshire Hathaway did. So we can say with a good degree of certainty that the negative possibilities decrease from -100% to -80% and the positive possibilities from +500,000% to +10,000% (The S & P 500 Index went up 6,840% in the same 43 year time period). So diversification decreases the possible variation of rate of returns from 500,100% to 10,080%. Quite a difference and why mathematicians were so impressed with diversification!

Now, I want you to look at the numbers again. The risk is uneven or skewed. The upside has much more potential than the downside. With diversification you really bring the upside potential down, but only reduce the downside potential by a little.

Warren Buffett does not believe in diversification as a strategy to reduce risk because of this skewed situation. He thinks one can pick companies that have good management, good cash flow, business plans that make sense, products or services that aren’t going out of style, and product or name recognition that creates a protective moat around the business. He has demonstrated he can pick good companies. There are many others that do the same thing, just not in a publicly owned company.

The key take-away from this post is to understand that systemic risk equals variance and that it is skewed toward positive results. Your fear of loss of all your money (as opposed to 80% of your money) is costing you much upside potential! My point isn’t to tell you not to diversify, but only to illuminate what it is costing you. Knowledge is king!

This 10 year chart of Berkshire Hathaway versus the S & P 500 Index I believe illustrates what I have been saying.  Note, the much tighter range for the S & P than Berkshire.  Berkshire has a much higher systemic risk (variance) than the diversified index!  However, the payoff for assuming this risk is in upside movement!

Next post we will discuss the non-mathematical aspects of risk!