Using The ‘Largest Position Filter’ in KINFO To Diversify Risk

Modern Portfolio Theory (MPT) is one of the biggest breakthroughs in the history of finance. The idea is simple: risk should be measured based on the relationship stocks in a portfolio have to one another. Let’s look at how KINFO users can put this idea into practice.

Allocating Risk

A collection of investment securities has a lower risk than one, individual asset. The underpinning of this finding is that various assets respond to different factors in the market. When numerous securities take different directions, the investor mitigates unsystematic risk. This type of risk emerges from factors influencing a particular stock.

This risk is different than systemic risk which cannot be diversified away. Systemic risk occurs when macro events like a recession or major political assassination destabilize investor confidence. Such events impact all stocks. While there is little an investor can do to escape systemic risk there is a practice that can reduce unsystematic risk: diversification. KINFO can help.

Strategizing for The Long-Term

KINFO users can filter their view of funds with the largest position feature. This drop down menu offers selections limiting the results to funds where the largest position is less than increments of 10%, 25%, 50% and 75%. Let’s look at a few examples.

Technology Crossover Management VII holds more than 28% of its assets in one stock (Netflix). Other holdings like GoDaddy Inc and Alarm.com comprise 23% and 22% of the total respectively. With a yearly return of 32.5%, these seem to be wise investment choices. However, there is an unseen picture behind this outperformance: concentrated risk. If just one of these three companies takes a misstep, the fund performance will drop precipitously.

Now, let’s look at a more diversified fund like Security Capital Research & Management Inc. There is not one holding representing more than 10% of the total value. However, this less aggressive approach delivers a lesser yearly return of just 14.2%.

Risk/Reward Tradeoff

Looking at these two funds illustrates the risk/return tradeoff. Aggressive investors are willing to expose their assets to more downside risk in hopes of outsized returns. Conversely, investors choosing funds like Security Capital Research & Management accept lower annualized growth for the peace of mind that unsystematic risk will weigh less on their holdings.

How many stocks does an investor need to reach a maximum level of diversification? Experts disagree. However, researchers at firms like Invesco favor a focused approach on fewer winners because they believe, “the more diversified portfolios become, the more likely a portfolio manager is to move towards market or benchmark returns.” The basis for this idea is research showing that the strategy of diversification to eliminate risk becomes less efficient with each added holding.

Most importantly, KINFO users have the power to decide for themselves how they want to approach risk management. Our goal is not to advocate any particular fund or strategy. Rather, our community-based platform is rooted in discussing ideas with other investors, sound analytics, and up to date reporting.

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