In investment, risk and return are related. In other words, the price of earning a return is accepting some level of risk. But not every risk is worth taking and one of those is the risk associated with individual stocks or sectors. Economists call this idiosyncratic risk. It relates to the peculiar, individual influences on a particular stock or industry. The general rule is the less diversified your portfolio, the more you are exposed to these granular risks.
Treasury Wine Estates (TWE) is the second-largest publicly traded wine maker in the world. This Melbourne-based company, created in 2011, is home to such brands as Penfolds in Australia and Beringer in the US Napa Valley. One of TWE’s fastest growing markets has been China, which is now the biggest market for red wine in the world. In fact, China’s drinkers last year consumed 1.86 billion bottles of red wine, an increase of 136% on five years before.
However, that pattern started to change recently as China’s president Xi Jinping announced an austerity drive and a crackdown on corruption. (Wine is frequently used to grease the wheels of business deals in China.) In January this year, TWE downgraded its earnings guidance, saying the crackdown on official gift giving in China was hurting sales volumes. The market response was dramatic, with the company’s shares dropping 20% in a single session.
This wasn’t just felt in Australia. In Europe, French drinks giant Rémy Cointreau announced in April, 2014 that sales of its cognac had slumped by more than 30% due to the crackdown on corruption in China.
So how do investors protect themselves against idiosyncratic risks like these? The most obvious way is to diversify. That means holding a large number of stocks and being exposed to a broad number of sectors. In a portfolio of just one stock or even five, TWE’s sudden fall from favour has an outsized impact. But in a portfolio of several hundred or even several thousand stocks, the idiosyncratic fortunes of a single company mean less.