Idiosyncratic risk is a form of investment risk; uncertainties and potential problems that are endemic to an individual asset (like a particular company’s stock) or group of assets (like a particular sector’s stocks). It is also referred to as a specific risk or unsystematic risk. Non-idiosyncratic risks or systematic (and systemic) risks, in contrast, affect the entire market as a whole. They include taxation policies, inflation, interest rates, and economic growth or decline. Here diversifying doesn’t help because these risks are broad, geo-political, earthquakes or commodity shocks (like the Saudi – Russian price war which lead to an overnight 30% drop in the price of black gold).
There are varied opinions amongst investors on whether a portfolio should hold concentrated positions or whether one should diversify your holdings as much as possible, the latter running the risk of returns replicating the broad market (just use a tracker).
As if global economic slowdown due to the Corona virus wasn’t enough for investors to worry about last week, Anglo American Platinum (Amplats) declared a Force Majeure this past Friday and cut its production forecasts significantly which led to a 14.3% drop in the share price. Amplats, the world’s largest platinum producer experienced an explosion on the 10th of February 2020 that led to Friday’s event. The company’s ACP phase A converter plant at the Waterval smelter complex in Rustenburg was damaged during this explosion. The share prices increased from R119 on the 10th of Feb to touch R139 per share as the company was able to switch to a second converter plant without negatively impacting its operations or production. It is this second converter plant, which continued to have inexplicable water presence, a dangerous situation when working with metals at very high temperatures, that was switched off this Friday. With the share price selling off 15% as a result.
The question is, how could you have known this was going to happen? Or should one rather always expect systemic risks and manage your positions by always questioning on how much damage will this position or holding cause if I am wrong? What will the impact on your portfolio be?
What could you have done to capture the recent returns in the Platinum industry while still managing single-stock risk? This is where diversification becomes key. By splitting your platinum allocation between just 2 stocks, Implats and Amplats you would have experienced a decline of only 1.4% on Friday compared to the 14.3% drop of Amplats. This makes sense because the price of platinum stocks are driven by the price of Platinum. Should the price of platinum double for example, each company mining platinum will experience a significant increase in share price. The same holds for other sectors, if the South African economic environment improves, all the banks in the financial sector will do well.
Is it really necessary to hold a concentrated position in one specific company who’s share price is driven by macro forces as opposed to company specific details or can you get a diversification of the returns from a sector at much less risk?