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Stock investing: Speculating versus investing

(MoneyWatch) One of the services my firm offers to prospective clients is an analysis of their portfolio holdings. They receive a 15-page analysis that shows how well they are diversified by asset classes. Typical portfolios include some holdings of individual stocks, as well as sector and country funds. We don't recommend investing in any of them, so we take the time to explain why: Investing in these three categories has more to do with speculation than investing.

Since these are such common "errors" I thought it worthwhile to do a series of articles explaining why such investments amount to legalized gambling. In today's piece, we begin by considering the term "risk."

Despite its spelling, risk is not a four-letter word, at least not in the colloquial sense. When it comes to investing, we need to distinguish between two very different types of risk -- good risk and bad risk. Good risk is the type you are compensated for taking. The compensation is in the form of greater expected returns. Bad risk is the type for which there's no such compensation; thus, it's called uncompensated risk. Let's begin by taking a look at examples of compensated risk.

Stocks are riskier than bonds. In order to entice investment, stocks must compensate investors by providing greater expected returns. For example, for the period from 1927 through 2011, the annual equity premium over one-month Treasury bills was 7.8 percent.

Just as stocks are riskier than bonds, the stocks of small-cap and value companies are riskier than their large-cap and growth counterparts. Therefore, they, too, must carry risk premiums. Individuals investing in these asset classes do so only because they expect to be compensated with greater returns. The annual risk premium for small-cap and value stocks from 1927 through 2011 was 3.2 and 4.7 percent, respectively.

We have seen how risk and reward are related in that investors taking greater risk receive compensation in the form of an expected risk premium. Remember, if the greater expected returns were guaranteed, there would be no risk and no risk premium. As a result, the compensation investors receive must always be considered a before-the-fact risk premium.

Now let's turn to the "four-letter" type of risk, the uncompensated kind.

Diversification of stock portfolios

As we have seen, stock investors face several types of risk. First, there's the idiosyncratic risk of investing in stocks. Second, various asset classes carry different levels of risks. Small-cap stocks are riskier than large-cap stocks, and value stocks are riskier than growth stocks. These two risks can't be diversified away. Thus, investors must be compensated for taking them.

The third type of stock risk is that of the individual company. The risks of individual stock ownership can easily be diversified away by owning passive asset class or index funds that basically own all the stocks in an entire asset class or index. Each of these vehicles eliminates the single-company risk in a low-cost and relatively tax-efficient manner. Note that individual asset class risk can also be addressed by the building of a globally diversified portfolio, allocating funds across the various asset classes of domestic and international, large and small, value and growth, real estate and emerging markets.

Individual investors can build portfolios that reflect their own unique ability, willingness, and need to take risk, tilting their portfolio to either higher or lower risk asset classes as best suits their personal investment plan. Since the risks of single-stock ownership can be diversified, the market doesn't compensate investors for taking that type of risk. This is why investing in individual companies has more to do with speculating, not investing. Rational investors only take risks for which they have an expectation of being compensated for taking.

The benefits of diversification are obvious and well-known. Diversification reduces the risk of underperformance. It also reduces the volatility and dispersion of returns without reducing expected returns. So a diversified portfolio is considered to be more efficient than a concentrated portfolio.

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