There was a popular Saturday morning cartoon in the 1990s called Captain Planet and the Planeteers. It was a show about five kids — the Planeteers — from all over the globe who were given rings with special powers by Gaia, the spirit of the Earth. Their powers ranged from cool — the American kid named Wheeler could control fire — all the way down to the the super lame; the Brazilian, Ma-Ti, had the ability to instill compassion into people and animals through telepathy. That has got to be the weakest super power ever imagined. Seriously horrible. Anyway, they would fly around in their zero-emission, solar-powered Geo-Cruiser (*cough* bullcrap *cough*) in order to fight polluting Eco-Villians across the globe, like the inexplicable half man/half pig, Hoggish Greedly. Their powers alone never seemed good enough to beat the bad guys, but they could combine them to summon Captain Planet, a green-mulleted, blue-skinned super hero that has all of their powers magnified. Captain Planet would then save the day and the credits would roll. So the moral I got from the story is we all kind of suck on our own, but we can be really great if we pool our assets.
I often try to steer clients away from making investments in individual stocks and bonds and towards investing in pooled vehicles such as mutual funds and exchange-traded funds (ETFs). The key reason is what’s known an unsystematic risk. Unsystematic risk can be specific to an individual company — such as Merck (ticker: MRK) withdrawing its blockbuster arthritis drug Vioxx from the market in 2004 because of its unfortunate potential side effect of giving people heart attacks and strokes, or BP’s (ticker: BP) tragic Deepwater Horizon explosion and subsequent oil spill in the Gulf of Mexico in 2010 which dramatically hurt the Alabama tourism industry (which I had no idea existed in the first place). It can also be specific to the industry a company operates in — such as how Russian fertilizer maker Uralkali’s July 30, 2013 announcement that it would withdrawal from the Belarus Potash Corporation export cartel sent shares of other potash manufacturers like the eponymous PotashCorp (ticker: POT) and Mosaic (ticker: MOS) tumbling, or the negative impact the 2007 introduction of the iPhone from Apple (ticker: AAPL) had on other mobile handset manufacturers like Nokia (ticker: NOK) and Motorola (ticker: MTI). Remember when we all had RAZR phones? Yeah, me neither.
Unsystematic risk is often referred to as diversifiable risk, because it can be diversified away by investing in many different companies across different industries. An investor wants to reduce diversifiable risk because it is not rewarded with a higher expected return, and why take a risk that you are not going to get paid for? A portfolio invested in only one or two stocks is going to be very volatile because of the risk specific to those names, but a portfolio of 20 stocks across a broad variety of industries (investing in 20 Canadian energy stocks doesn’t count) will have reduced a good junk of that risk. Beyond 40 unrelated stocks most of the unsystematic risk has been eliminated in a portfolio, but any additional names will still result in a reduction — albeit increasingly small — in risk. What remains is what is called systematic risk. This is the general risk to the broader market, and it cannot be diversified away.
Mutual Funds and ETFs can help small and large investors alike greatly reduce unsystematic risk by pooling assets together and investing in hundreds of different securities, often at a very low cost. I also find that investors are less prone to making behavioral mistakes with Mutual Funds and ETFs that track broad indexes than they are with individual securities. We beat ourselves up over selling winners too early, or we get attached to losers and hold onto them too long because we are hoping to be proved right some day. We also feel a sense of regret when we miss out on the latest hot stock. Stick to pooled funds and you will avoid some of the emotional stress that comes with investing. The power is yours.
