“Big Blue”, the less-than-creative nickname for enterprise technology stalwart IBM, is certainly feeling the blues this week.
On Tuesday this week, the company did something unusual, and by unusual, I mean I haven’t been able to find another example in its 115-year history. It couldn’t wait for its scheduled earnings date of July 22 (yes, only 8 days from this past Tuesday), so it pre-announced. CEO Arvind Krishna sent a letter to investors admitting the company had “faltered,” and released preliminary second-quarter numbers. The verdict from the market was swift and merciless. IBM shares fell 25% in a single session, the worst single-day drop in the company’s history. And remember, I said earlier, their 115-year history, which stretches back through the Great Depression, Black Monday, the Dot-Com bubble, and the Great Financial Crisis. Roughly $67 billion in market value was gone before lunch.
Now, here’s the part that makes this even more interesting. Their earnings were not a catastrophe on paper. IBM announced $17.2 billion in revenue against a consensus of $17.9 billion. That’s a miss of roughly 4%. Adjusted earnings came in at $2.93 per share versus expectations of around $3.02, a shortfall of about 3%. In the grand scheme of a company that generates tens of billions in annual revenue, these are rounding errors. A 3% miss is the kind of thing a CFO can sometimes explain away with a shrug and a mention of “deal timing.”
So what was different here? Well, the market wasn’t reacting to the number itself. It was reacting to the reason for the number. Krishna explained that in the final weeks of June, IBM’s enterprise clients abruptly reprioritized their budgets, yanking dollars away from IBM’s software and mainframe products and instead prioritizing AI hardware, servers, storage, and memory chips, in a scramble to lock in supply (remember our article on High Bandwidth Memory). In other words, investors are concerned the miss may not be one-off stumble, but the first crack in the foundation. If customers are raiding their IBM software budgets to feed the AI hardware beast, is this one bad quarter, or the opening chapter of a structural problem? The market, forced to answer that question in real time, chose to sell first and ask questions later.
That gap, the chasm between a 3% operational miss and a 25% price collapse, is one of the most important lessons in all of investing. And it has a name.
The Risk With Your Name On It
There are two flavors of risk that live inside every stock you own, and most people only ever think about one of them.
The first is called idiosyncratic risk (sometimes called “unsystematic risk”), which is a fancy way of saying “the stuff that can go wrong at this specific company.” A key executive leaves. A drug fails a trial. A factory burns down. A CEO tweets something regrettable. Or, in IBM’s case, enterprise customers quietly decide, over the span of a few weeks, that they’d rather buy AI hardware than renew their mainframe software licenses. Idiosyncratic risk is company-specific. It is the risk that is unique to the ticker, the risk with the company’s name stamped on it.
Here is the crucial and counterintuitive truth about idiosyncratic risk: it is largely unpredictable and almost never priced into a stock’s day-to-day trading. Ask anyone who owned IBM last Monday. On paper, it was a stable, dividend-paying, blue-chip technology company. It’s the stock your grandfather owned. It is the definition of “safe.” Nobody looked at their IBM position on Monday evening and thought, “You know what could happen tomorrow? A 25% drop.” The whole point of idiosyncratic risk is that it ambushes you. If everyone saw it coming, it would already be priced in.
This is why concentration is so seductive and so dangerous. When you hold a big slug of a single company, you are not just betting on its business. You are unknowingly taking on every weird, unforeseeable, company-specific event that could crawl out of the woodwork on a random Tuesday in July.
The Tsunami That Hits Everyone
The second flavor is systematic risk, sometimes called market risk. This is the stuff that doesn’t care which stocks you own. A recession. A financial crisis. A pandemic. An interest-rate shock. A war that spikes oil prices. When systematic risk shows up, it doesn’t show up at just one company. The tsunami is showing up for the whole neighborhood. In 2008, it didn’t much matter whether you owned the “good” bank or the “bad” bank; the tide went out on everyone at once.
The important distinction is this: systematic risk is the price of admission for being in the market at all. You cannot diversify your way out of a global financial crisis because, by definition, it touches everything. It is the risk you are being compensated to bear over the long run. It’s the reason stocks return more than savings accounts; you are paid to endure the occasional gut-wrenching, everything-drops storm.
And this is very different from idiosyncratic risk. Because idiosyncratic risk is the risk you are not compensated for, because you don’t have to take it at all.
The Only Free Lunch
There is an old saying, often attributed to Nobel laureate Harry Markowitz, that diversification is the only free lunch in investing. It sounds like an overused phrase that you’d find on a finance professor’s coffee mug. In reality, it’s mathematically sound, and IBM’s Tuesday is the perfect illustration of why.
Think about what a 25% drop in a single stock does to a portfolio. If IBM is 100% of your holdings, you just lost a quarter of your net worth in a morning. If IBM is one of forty roughly equal-weighted positions, that same brutal, headline-grabbing collapse costs you about 0.6% of your portfolio. It’s the same numbers, the same shocking headline, but with wildly different consequences for your actual life.
That is the mechanical magic of diversification. While it does not, and cannot, protect you from systematic risk, it very nearly eliminates idiosyncratic risk. When the whole market falls, a diversified portfolio falls too, but when a single company flames out, a diversified portfolio saves the day, and it does so essentially for free. You don’t have to sacrifice expected return to get diversified. You are simply declining to make an uncompensated bet and take the risk that one specific company has an unforeseeable event.
The reason this feels unsatisfying is that diversification is boring. When you spread your money across dozens or hundreds of companies, no single one of them can make you spectacularly rich overnight. But the flip side is the whole point, as no single one of them can wreck you overnight, either. The IBM holders who were impacted most on Tuesday were the ones who had decided, consciously or not, that Big Blue was too safe, too blue-chip, too permanent to need diversifying around. Blue chips have idiosyncratic risk too. They just hide it better, until they don’t.
What Big Blue Reminds Us
Nobody (well, almost nobody) is saying IBM is doomed. It may well recover, patch up its software business, and ride the very AI wave that just knocked it over. The earnings call will tell us more, and IBM clearly wanted to get ahead of the story rather than let it fester for another week.
But that’s a question for IBM shareholders. The lesson for the rest of us is broader and older than any single company. Every stock carries two kinds of risk. One of them, the market-wide storm, you cannot avoid, and you shouldn’t try, because it’s what pays you to be an investor in the first place. The other, the company-specific ambush, you can avoid almost entirely, and for no cost beyond a little discipline and the willingness to be boring.
IBM’s shareholders learned this week that a 3% miss can become a 25% crater, and that violent swings are not just for small startups. The good news is that it’s a lesson you can learn secondhand, from the comfort of a well-diversified portfolio, as you watch just a sliver of your portfolio have a very bad Tuesday.
Markets / Economy
- The first signs of instability in the AI trade appeared this week, with declines across the high-flying memory names. The S&P finished the week down -1.6%, the Nasdaq down -2.9%, and the small-cap Russell 2000 down -0.5%.
- U.S. core inflation fell to 2.6% in June from a seven-month high of 2.9% in May and below the expected 2.8%.
- Total CPI fell to 3.5% in June, the first decline in five months, compared to 4.2% in May and below forecasts of 3.8%.
- The University of Michigan’s Consumer Sentiment Index rose to 54.4 in July, beating expectations of 51.0 and marking a second straight monthly increase after May’s record low, according to the preliminary estimate.
Stocks
- U.S. equities were in negative territory. Technology and Consumer Discretionary led the decline, while Energy and Real Estate outperformed. Value stocks led growth stocks, and small caps beat large caps.
- International equities closed lower for the week. Developed markets fared better than emerging markets.
Bonds
- The 10-year Treasury bond yield decreased one basis point to 4.55% during the week.
- Global bond markets were in positive territory this week.
- Government bonds led for the week, followed by corporate bonds and high-yield bonds.
