How to Minimize Uncompensated Risk
Contributor Scott Simon illustrates how reducing this risk can damp portfolio volatility and improve investor outcomes.
There are lots of different kinds of investment risk, including inflation risk, credit risk and interest-rate risk. However, what I term modern prudent fiduciary investing--that is, the Restatement (Third) of Trusts and the Uniform Prudent Investor Act--is grounded in Modern Portfolio Theory. As a result, it’s concerned primarily with the nature of portfolio risk and how to diversify it prudently. So let’s see what that means.
The total risk carried by a portfolio of stocks--or a single stock or mutual fund, or fixed income investments, for that matter--can be separated into two kinds: uncompensated risk, which comprises about 70% of total portfolio risk, and compensated risk, which comprises about 30%.
W. Scott Simon does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.