Uncompensated Risk – Understanding and Managing It in Your Investment Portfolio

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Written By
Contributor Image
Written By
Dan Buckley
Dan Buckley is an US-based trader, consultant, and part-time writer with a background in macroeconomics and mathematical finance. He trades and writes about a variety of asset classes, including equities, fixed income, commodities, currencies, and interest rates. As a writer, his goal is to explain trading and finance concepts in levels of detail that could appeal to a range of audiences, from novice traders to those with more experienced backgrounds.

In trading and investing, risk is always a factor. If you don’t take enough risk, you won’t make any money. If you take too much risk, it’ll be hard to keep any.

But not all risks are equal.

Understanding the concept of uncompensated risk is important for anyone looking to optimize their portfolio and maximize returns.

Below we look into:

  • the nature of uncompensated risk
  • distinguish it from compensated risk
  • provide examples of uncompensated risk in portfolios
  • discuss the consequences of not addressing it, and
  • suggest ways to avoid or minimize it

Lastly, we will contextualize uncompensated risk within the framework of portfolio theory.


Key Takeaways – Uncompensated Risk

  • Risk is an inherent factor in trading and investing. Finding the right balance is important: too little risk leads to limited returns, while too much risk increases the odds of unacceptable drawdowns.
  • Uncompensated risk, also known as unsystematic or diversifiable risk, is specific to individual assets or industries and can be mitigated through diversification.
  • Diversification is vital to minimizing uncompensated risk.
  • By spreading investments across various asset classes, industries, and geographic regions, traders/investors can reduce the negative impact of individual assets and enhance their portfolio’s risk-adjusted returns.


Definition and Explanation of Uncompensated Risk

Uncompensated risk, also known as unsystematic or diversifiable risk, is the type of risk that is unique to a specific asset or industry and can be mitigated through diversification.

This risk originates from factors such as management decisions, labor strikes, product recalls, among any number of company-specific events that impact individual companies or industries but not the entire market.

Unlike systematic risk, which is inherent to the market and cannot be eliminated, uncompensated risk can be reduced by holding a diverse portfolio of assets.

For example, interest rates apply to the whole market and a rise in interest rates would be considered a form of systematic risk to a financial asset portfolio.

A product recall at a specific company would be an example of unsystematic risk. Being clipped by something like this can be avoided by avoiding having concentrated exposures to individual assets and by diversifying broadly.


Differences between Compensated and Uncompensated Risk

Compensated risk, also known as systematic or market risk, is the risk associated with the overall market or economy.

This type of risk affects all assets in a portfolio, and investors are rewarded with higher returns for taking on higher levels of systematic risk.

Examples of compensated risk include changes in interest rates, inflation, or political instability.

Since this risk cannot be eliminated through diversification, investors are said to be “compensated” for taking it on through higher expected returns.

On the other hand, uncompensated risk does not offer any additional expected return for taking it on, as it can be minimized or eliminated through diversification.

By holding a diverse portfolio, traders/investors can offset the negative impact of individual assets with the positive performance of others.


Examples of Uncompensated Risk in Portfolios

An example of uncompensated risk can be seen in a portfolio heavily invested in a single industry, such as technology.

If a regulatory change or technological disruption adversely affects this industry, the entire portfolio may suffer.

Similarly, a portfolio with a large concentration in one company, like Apple, Berkshire Hathaway, Google, or Tesla, exposes investors to uncompensated risk tied to the company’s performance and the factors affecting it.


Consequences of Uncompensated Risk

Failing to address uncompensated risk can lead to increased volatility and potential losses in a portfolio.

By not diversifying, investors may experience greater fluctuations in their investments’ values. This could result in underperformance compared to the broader market.

It can also be harder to stomach and cause the trader to make certain decisions they wouldn’t make otherwise.

Moreover, they might have a “hole” in their portfolio where the concentration causes them to miss out on potential gains from other assets or industries that could have offset the negative performance of some investments.


Ways to Avoid Uncompensated Risk

To minimize uncompensated risk, investors should diversify their portfolios across various asset classes, industries, and geographic regions.

By holding a mix of stocks, bonds, commodities, and real estate, as well as investments in different sectors and countries, investors can reduce the impact of any single asset or industry on their overall portfolio performance.


Uncompensated Risk in the Context of Portfolio Theory

Modern Portfolio Theory (MPT), developed by Harry Markowitz, posits that investors can optimize their portfolios by selecting a mix of assets that maximizes expected return for a given level of risk.

MPT emphasizes the importance of diversification in reducing uncompensated risk while accepting a certain level of compensated risk to achieve the desired portfolio performance.

By understanding and managing uncompensated risk, investors can make more informed decisions to achieve their financial goals and enhance their portfolio’s risk-adjusted returns.


FAQs – Uncompensated Risk

What is the main difference between compensated and uncompensated risk?

The primary difference lies in their diversifiability.

Compensated risk (systematic risk) affects the entire market and cannot be diversified away, while uncompensated risk (unsystematic risk) is specific to individual assets or industries and can be reduced through diversification.

How can I determine the level of uncompensated risk in my portfolio?

To assess the level of uncompensated risk, analyze the concentration of your investments in specific assets, industries, and geographic regions.

A portfolio heavily invested in a single industry or company is more exposed to uncompensated risk.

Can I completely eliminate uncompensated risk from my portfolio?

While it’s impossible to eliminate all uncompensated risk, traders/investors can significantly reduce it through diversification.

Holding a well-balanced mix of assets from various industries and geographic regions can minimize the impact of individual assets on your overall portfolio performance.

How does Modern Portfolio Theory (MPT) help in managing uncompensated risk?

MPT suggests that investors can optimize their portfolios by selecting a mix of assets that maximizes expected return for a given level of risk.

By emphasizing diversification, MPT helps reduce uncompensated risk while accepting a certain level of compensated risk to achieve desired portfolio performance.

Is it possible for a well-diversified portfolio to still be affected by uncompensated risk?

Even a well-diversified portfolio may be exposed to a certain degree of uncompensated risk.

However, the impact of this risk on the overall portfolio performance is significantly diminished compared to a less-diversified portfolio.

How can I diversify my portfolio to minimize uncompensated risk effectively?

Traders/investors can diversify their portfolios by allocating their investments across various asset classes (stocks, bonds, commodities, and alternatives), industries, and geographic regions (which also can provide currency diversification).

This can be achieved by investing in mutual funds, exchange-traded funds (ETFs), or directly purchasing individual assets.

What are some common mistakes investors make in terms of uncompensated risk?

Common mistakes include overconcentration in a single asset, industry, or geographic region, failing to rebalance the portfolio periodically, and not considering correlations between different assets (i.e., how are they fundamentally different or the same) when constructing a portfolio.