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Stock Market Cycles

Little risk mitigation comes from owning an individual common stock or sector that responds to the same underlying expected earnings and risk factors. For example, a portfolio of two U.S. car manufacturers or several major, domestic U.S. airlines has very little risk mitigation from diversification. Investors must analyze the specific risks associated with an individual common stock or industry sector.

Portfolio concentration increases the possible return as well as the risk. As concentration increases, company-specific risks are more pronounced. As diversification increases, company-specific risks are mitigated. General common stock market risks can never be eliminated or reduced unless combined with other categories of assets, such as money market funds and bonds.

What categories of specific risks must investors in individual common stocks identify?

Categories of specific risks can be identified. Investors should focus on these categories and be alert for changes. Changes in any identified category cause changes in the valuation. Investors must incorporate these specific risk categories into the Equation (3) valuation framework for individual common stocks.

Investors’ valuation of individual common stocks, unlike that of a well-diversified portfolio, must recognize increased risk by adding a required return in the denominator of the Equation (3) valuation framework. In effect the risk is “built-up” in the denominator as each category of specific risk is included. Financial jargon frequently refers to the resulting valuation framework as the “build-up” model. The risk build-up of the denominator in the Equation (3) valuation framework reconfigures it from:

P = It = 1, = E_t(1 - A)/(1 + r)^t (3)

to:

P = It = 1, = E_t(1 -A)/(1+i + p + e + s + b + f+m + o)^t