The  advantages of diversifying investments to remove systematic risk. A review into the effects of unsystematic risk on the oil industry compared to the FTSE 100 (February 2014-February 2015)

Transocean’s shares have fallen by 58% since late June, when oil prices began tumbling… the company also said it would ask shareholders to approve an 80% cut in its quarterly dividend to 15 cents from 75 cents a share

(Molinski & Sider, 2015)

Such news is bad for shareholders of the company, and I believe portrays more than ever the risks involved of investing in the stock market. However I wish to use such a case to see whether a diversified portfolio really reduces unsystematic risk. There are two ways that unsystematic risk can be diversified away:

•       Companies can minimise unsystematic risk by diversifying their operations by investing in a number of unrelated
•        Investors can reduce unsystematic risk through holding a diversified portfolio of shares

However the best way to eradicate unsystematic risk is at an investor level due to the difficulty of operating in diversified business areas and the potential loss of economies of scale (Watson & Head. (2010). Thus individual companies can be very prone to systematic risks, for example Swiss company Transocean Ltd invests in opportunities directly related to extracting oil, whilst it may have achieved economies of scale and expertise in this area, Figure’s 1 and 2 show just how much the company’s share price has been influenced by the recent decline in oil price, with the firm’s 66% fall in share price coinciding with the 60% fall in oil prices since peaks in June.

Figure 1: Transocean Ltd. Share Price

(Yahoo Finance, 2015)

Figure 2: Oil Price

                                          

(Yahoo Finance, 2015)

However as stated before it is much easier for investors to minimise systematic risk through a diversified portfolio. The number of stocks needed to create a diversified portfolio varies on literature, Evans & Archer (1968) stated about 10 stocks will do, however research by Statman (1987) said this isnt sufficient to reduce unsystematic risk and a portfolio of atleast 30 is needed. The FTSE 100 tracker includes a diversified portfolio of stocks (Thomas, 2015), and thus in relation to figure 3, should reduce the risk shareholders obtain by investing in the stock market, by mininmising the unsystematic risk. However Solnick (1974)  did state a diversified porfoilio of shares from major stock markets around the world can further reduce unsystematic risk.

Figure 3: Amount of unsystematic risk diversification obtained as number of investment increases

(Watson & Head, 2010)

When analysing the FTSE 100 stock worth in the same period it certainly appears that it is a lot less affected by unsystematic risk, with largest decrease in price less than 10% . Furthermore when analysing Figure 4 and its relationship to the previous two graphs it appears there is no relation to the decrease in price of oil (an unsystematic risk) and the worth of shares within the FTSE 100.

Figure 4: FTSE 100: Stock Index

(Yahoo Finance, 2015)

Thus in relation to the previous year it appears a diversified portfolio – such as the FTSE 100 – does help minimise the unsystematic risks shareholders will obtain. I have found it very interesting how this is achieved, with the varied range of businesses offered in trackers appearing to prevent the large unsystematic risks which effects businesses - and shares - restricted to a particular industry will obtain.

References

Evans, J. & Archer, S. (1968). Diversification and the Reduction of Dispersion: An Empirical Analysis. Journal of Finance (23), 761-767

Monlinski, D. & Sider, A. (2015, February 16). Transocean CEO and President Steps Down. The Wall Street Journal. Retrieved from http://www.wsj.com/

Solnik, B. (1974). Why not diversify internationally rather than domestically? Financial Analysts Journal (30), 48-54

Statman, M. (1987). How Many Stocks Make a Diversified Portfolio. Journal of Financial and Quantitative Analysis (22)3, 353-363

Thomas, H. (2015, March 1) How to build a perfect Isa portfolio. The Telegraph. Retrieved from https://uk.finance.yahoo.com

Watson, D. & Head, A. (2010). The concept of diversification in Watson, D. & Head, A. (Ed.5). Corporate Finance Principles & Practice. Harlow: Pearson

Yahoo Finance (2015). FTSE 100. Retrieved from https://uk.finance.yahoo.com

Yahoo Finance (2015). Crude Oil. Retrieved from https://uk.finance.yahoo.com

Yahoo Finance (2015). Transocean Retrieved from https://uk.finance.yahoo.com