The risk and rewards of diversification

Regardless of how financially sound a company is or how strong a reputation it has, it is not immune from single event shocks or unsystematic risk.

In September, Volkswagen’s cheating of US emission tests resulted in the stock plunging 45%. Occurring at what was a sensitive time for markets this led to a global contagion with the DAX being impacted by 8% and the MXWD by 6%.

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Whilst the indices have largely recovered Volkswagen still lags significantly. The magnitude of this fall demonstrates the dangers of concentration. Diversification is normally positive but in Volkswagen’s case its global diversification is negative since the problem product (‘emissions’) is not diversified. Although the issue arose in the US the fact that the problem is global makes it financially serious.

In June, Nestlé suffered serious reputational risk as noodles manufactured and sold in India were alleged to have excessive lead content. In this situation Nestlé SA fell 8% and the SMI 6%. These recovered to previous levels.

The difference between these two companies, which both operate in over 150 countries, is that Nestlé has over 2,000 brands covering almost every food and beverage category compared to Volkswagen that has only 12 brands, all of which are vehicles with ‘emissions’.

We have no doubt Volkswagen will survive this unsystematic shock, as has BP plc, following their oil-spill in 2010, but it highlights the dangers of single stock risk.

At Camomille in building our portfolio we seek to diversify as much as possible, thus eliminating unsystematic risk and spreading systematic risk. We use equity indices to reduce single stock risk and allocate our risk globally between developed and emerging markets to reduce country and regional risk. We further diversify equity systematic risk by incorporating a commodity component (gold and oil).

Systematic & Unsystematic Risk Chart