What Is Uncompensated Risk And How To Avoid It

What Is Uncompensated Risk And How To Avoid It
Underwater by Julian Cohen. Why?

You bump into an incredible number of risks when you invest your money, but exposing it to uncompensated risk is voluntary, as you’ll see below.

It’s Surprising How Many People Take On Uncompensated Risk When They Don’t Need To

Are You Taking On Uncompensated Risk For Free?

Investing should be about controlling risk and accepting the returns you get. 

Yet many people seem to invest the wrong away around. 

They chase the returns they want and accept the risk they get. 

As this often includes uncompensated risk, it’s worth a look at both compensated risk and uncompensated risk in a bit more detail.

That’s because accepting uncompensated risk is largely optional.

What Is Compensated Risk?

If you accept a compensated risk, you’re hoping to increase the expected return on your investment, although the return is not guaranteed.

Here's An Example Of Compensated Risk

Instead of investing in a bank deposit account, you invest in stockmarket assets. 

Whilst the bank deposit account will pay you a known rate of return, your expected return from your stockmarket assets will be higher, as a result of taking on the performance risk of the underlying companies.

You’re compensated for taking on a greater risk, because the investment returns are volatile.

What Is Uncompensated Risk?

Uncompensated risk is a risk that doesn’t increase the expected return on investment. 

It’s a widely accepted adage that you can’t get high returns without taking on high risk. 

But academics point out that the relationship of more risk, more reward doesn’t always hold true. 

Sometimes when you take greater risk, you don’t always see a greater return. 

It may actually decrease the expected return. 

Here's An Example Of Uncompensated Risk

The classic example of uncompensated risk is buying shares in one company, compared to investing across the stockmarket.

Suppose you expect shares in Marks And Spencer to give you an average annual return of 5 per cent over the coming years.  And you also believe the wider stockmarket will deliver an average of 5 per cent.

It goes without saying that the value of Marks And Spencer shares could go up and down.  And the same applies to every other share quoted on the market.

The performance of each share is not just dependent on the trading results of the company.  It’s also exposed to a huge number of risks, some of which were covered in our recent article entitled What Is Investment Risk And How To Avoid It?

Marks And Spencer shares may do very well, whilst others may suffer substantial difficulties, including some that might go bust.  However, it’s virtually impossible for all companies in the market to suffer the same business disasters at exactly the same time.

If you’ve got all your money in one stock, it follows that you’re taking on a lot more risk than the market, including the risk of losing all your money. 

It's pretty much impossible for every company quoted on the stockmarket to go bust at the same time.

And that is uncompensated risk.

How To Reduce Uncompensated Risk

It’s not rocket science. 

By investing in the shares of more than one company, you reduce the specific company risk.

Calculations estimate that by holding at least 20 shares, you remove the majority of the uncompensated risk. 

Hold more than 100, and you’ve reduced uncompensated risk to such a degree, it’s no longer a concern.

Obviously, if you buy a whole of market index tracker fund, you’ve removed it altogether.

Reducing uncompensated risk was perfectly articulated by John Bogle, the founder of Vanguard.  He said:

Don’t look for the needle in the haystack.  Buy the whole haystack.

The Uncompensated Risk Takeaway

According to the academics, a risk that can be easily diversified away cannot be expected to reward you with higher returns. 

The solution is obvious. 

Diversify your investments and remove the uncompensated risk.

After all, you bump into plenty of other risks when you invest, so why voluntarily accept another one?

Of course, if you want to take a punt on a particular stock, that’s a different matter.  But be aware that simply increasing your risk to well above the average doesn’t necessarily mean you’ll be compensated with an equivalently high return!

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