Most Popular ArticlesSeptember 1, 2009
Quantifying risk
Mr. Katz repeatedly refers to my model portfolio as ‘riskier’ than the original Merriman portfolio and criticizes my use of trailing three-year statistics in the article. Fair enough – but looking at longer time periods merely reinforces by analysis. I used the trailing three-year period to illustrate certain examples, but the model portfolio that I proposed is less risky than the Merriman portfolio on a wide variety of time horizons:
The first row of this table shows the annualized volatility and Beta (with respect to the S&P500) for my New Normal portfolio and for the Merriman portfolio for the three years through July 09. The next three rows show the same statistics for a variety of time horizons, including one (row 4) that excludes the most recent two years that Mr. Katz believes are a statistical anomaly. In every period, the Merriman portfolio has higher Beta and higher volatility than my proposed New Normal. Mr. Katz, however, repeatedly says that my model portfolio is riskier than the basic Merriman portfolio—without ever providing any quantitative measure of risk to back this up.
Mr. Katz’s assertions that my New Normal portfolio is riskier than the Merriman portfolio is based on the following:
- The Merriman portfolio contains allocations to 11,000 stocks via market-cap weighted funds
- The Merriman portfolio has less default risk from individual stocks because it holds so many stocks
- The Merriman portfolio is better diversified because it holds so many stocks
- The Merriman portfolio is less risky because it holds more bonds
These arguments may hold sway with a lay investor, but each of these has problems from the perspective of academic finance.
I am not aware of any analysis that supports the idea that you need thousands of stocks to be well-diversified. There are routinely articles that attempt to estimate how many randomly chosen stocks are required to diversify away as much non-systematic risk as possible. Recent estimates suggest that holdings on the order of 100-200 randomly selected stocks are sufficient to minimize the impacts of individual stock risks, even if the stocks are chosen randomly. Holding 11,000 securities is simply redundant.
Further, while Mr. Katz asserts that non-systematic risk is to be avoided because of the classical CAPM notion that this risk is not rewarded, more recent research suggests that the company specific risks are, in fact, rewarded with additional return. In the old CAPM world view, it was desirable to minimize stock-specific exposure because the risk associated with individual stocks was simply additional risk for which an investor could expect no reward. The recent research suggests that this is not the case, so the old argument that it was wise to simply buy many stocks is not justifiable.
Finally, Mr. Katz asserts that the high historical Beta of the Merriman portfolio (which substantially increases the portfolio’s exposure to market risk) can be ignored because simply looking at the percentage of the portfolio allocated to bonds as a proxy for risk is “more concrete and easier for clients to understand than speaking about Beta.” People may have a hard time grasping Beta, but it is a crucial measure of market exposure.
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