Weathering Earnings and Managing “Idiosyncratic” Risk

As earnings season approaches, your portfolio may be subject to violent moves in the market as companies report their quarterly earnings and provide guidance on what to expect in the months ahead. Corporate earnings can boost your portfolio if the companies you hold do well. But earnings that come in below expectations can certainly leave a mark. It all depends the companies, industries, and sectors in your portfolio—and their concentration.

How might you weather the potential storm clouds accompanying each quarterly earnings season? Let’s take a closer look at the risks and discuss a few ways to attempt to protect your portfolio from the potential volatility ahead.

Today’s Buzzword: Idiosyncratic Risk

Ever heard of the term idiosyncratic risk? It’s a fancy way of describing the risk you face when your portfolio is too concentrated in a given company, industry, or sector. If you hold too many shares of one stock, or too many stocks within a single industry or sector, you may be vulnerable to idiosyncratic risk.

Why? Because if a single company that’s a major component of your portfolio were to report poor revenue growth or miss consensus earnings expectations, your portfolio could sink along with the company’s share price. Or suppose the demand for goods and services in an entire sector (e.g., Technology or Consumer Discretionary) begins to decline. If your total equity holdings are overconcentrated in luxury apparel, autos, entertainment, or any other sector component, you could see outsize downward movement in your portfolio.

Here’s a simple, at-a-glance way to tell if you might be overconcentrated. If most or all of your stocks are heading in the same direction—whether profit or loss—while stocks in other sectors are moving in different directions, then you may have a diversification problem. So how might you address it?

How to Weather Earnings Volatility: Diversify ... But Don’t Overdo It

If your portfolio is well diversified, some of your stocks may perform better than others at various times, with the ultimate goal of higher risk-adjusted returns. But how many different stocks do you need to be considered “fully” diversified? Would 10 do it, or 100? And how might you know if you’re too diversified (overdiversified), meaning your returns are getting incrementally smaller the more stocks you add?

According to the book Investment Analysis and Portfolio Management by investment researchers Frank Reilly and Keith Brown, “About 90% of the maximum benefit of diversification was derived from portfolios of 12 to 18 stocks.” According to the authors’ research, an investor can get more than 90% of the potential benefits of diversification by owning as few as 12 to 18 stocks. That’s a pretty small basket. (Of course, you want to make sure your portfolio is appropriately weighted.) But keep in mind asset allocation and diversification don't eliminate the risk of experiencing investment losses.

Once your portfolio is adequately diversified, adding more stocks may not add much more value—and it could even begin to reduce your portfolio’s value. That’s known as “overdiversification,” and it can happen if the marginal benefit of adding more portfolio components is outweighed by the added risk—not to mention the added complexity—of those extra components.  But if your portfolio is well balanced and diversified, even with fewer than 20 stocks, you may be able to weather the violent fluctuations that often come when companies conduct their quarterly reporting.

Might Eliminating Idiosyncratic Risk Help Create an All-Weather Portfolio?

The answer is no. You can’t eliminate risk from investing; there’s no such thing as a risk-free investment. Not even cash is risk-free—its purchasing power tends to decline over time because of inflation. 

By aiming to eliminate idiosyncratic risk—the risk that an individual company, industry, or sector may underperform and directly affect your entire portfolio—you’re shifting closer to a level of diversification that resembles a broad market index like the S&P 500 Index. But even the highly diversified S&P 500 is vulnerable to what finance professionals call systematic risk. Let’s briefly discuss this.

Your portfolio’s performance is generally tied to two factors: how well businesses perform, and how well the economy performs. If you hold a well-diversified portfolio and one factor outperforms the other, then you may benefit from diversification either by mitigating losses or by generating profits from a portion of your stock holdings.

But when the entire economy performs poorly, affecting many or most businesses, you may be vulnerable to declines—bear markets and recessions—that impact the the broader market. That’s systematic risk, and it’s an unavoidable part of the economic cycle. (Although there’s no way to eliminate systematic risk, there are a few ways to try to mitigate or even take advantage of down periods in the market.)

The Bottom Line on Idiosyncrasy

Although earnings season can be a volatile time in the markets, you need not be intimidated if your portfolio is diversified enough to withstand some potential shocks. By managing your exposure to idiosyncratic risk, you might not benefit from the skyrocketing potential of an overly concentrated portfolio, but you may mitigate the damage that could be done by a single earnings miss. Overall, it can sometimes be better to play it safe than to go for broke.