Tuesday, August 17, 2010

Portfolio Construction Taking into Account Employment

Taking into account the nature of your employment when constructing your investment portfolio makes sense. Stock brokers may not want to expose their portfolios to too much stock market risk because their wages depend on the stock market performing well. However, paying too much attention to risk at the expense of expected returns can lead to problems.

In his book, Your Money Milestones, Moshe Milevsky quotes a study saying that MBA students interested in a Wall Street career should consider shorting the stock market upon entering school.

This is a good example of focusing on risk at the expense of expected returns. It is definitely true that these MBA students are exposed to stock market risk. If the markets perform poorly while they study, their job prospects upon graduating may be grim. Shorting the stock market would yield profits in this case and reduce their overall financial risk.

However, stocks have a built-in tendency to go up. We may disagree on how large the risk premium is, but it does exist. Another point is that those who short stocks are charged a form of interest on the borrowed stocks. This interest would build up over the course of a few years.

If the stock market remained exactly flat while the MBA student studied, he or she would lose money on the short position and would probably run into a tough job market.

It is dangerous to focus on expected returns and ignore risk. But it is also dangerous to focus entirely on risk and ignore expected returns. Constructing a sensible portfolio requires taking into account both factors.

6 comments:

  1. Interesting point. With the up and downs of the market in recent years, it's likely that many people have placed too much emphasis on eliminating risk (ie. going to all GICs) and missed out on some decent returns.

    Overall, whether too much or too little risk is taken, I suppose it's always a step towards understanding one's personal risk tolerance

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  2. @Tiny Potato: Understanding your risk tolerance is important, but I've found that as my understanding of investing has improved, my risk tolerance has changed. I used to be too risk averse in some ways and too risk tolerant in other ways. I'm more relaxed about risk now and I avoid big risks that I didn't used to recognize as big risks.

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  3. I work in the technology sector. I definitely try to avoid the tech sector in my investments, and definitely will not buy my own company's stock for hedging.

    Does anyone know of a way to hedge against the tech industry?

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  4. Risk can be minimized without running away from the stock market. If you can minimize risk (not completely eliminate it) while allowing for some significant potential returns, you're on your way to a growing portfolio!

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  5. Indeed, if I'm allowed to ignore expected returns, I can eliminate investment risk altogether: don't invest your money!

    Another example of this is people looking for negatively-correlated asset classes. Done properly, this can simultaneously improve risk and return (this is what diversification is all about). However, it's easy to focus on correlation at the expense of return. In the extreme, it is possible to construct a portfolio of completely uncorrelated assets buy shorting the same assets you own, but clearly that would not be a wise course of action.

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  6. @Anonymous: I work in the technology sector as well. The only exception I'd make to about owning stock in my employer is some sort of savings plan or option plan that allows me to buy at a discount and sell fairly quickly. My way to under-represent tech stocks in my portfolio is to own the index plus some extra in Bank of Montreal and Berkshire Hathaway.

    @Doctor Stock and @Patrick:
    I agree. Risk is important, but isn't the only consideration. Just because two investments are negatively correlated doesn't mean that owning both is a good idea. This happens when there is a sufficient difference in their expected returns.

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