Unsystematic Risk - Unsystematic risk is sometimes referred to as "specific risk". This kind of risk affects a very small number of assets. An example is news that affects a specific stock such as a sudden strike by employees. Diversification is the only way to protect oneself from unsystematic risk.
Low levels of uncertainty (low risk) are associated with low potential returns, whereas high levels of uncertainty (high risk) are associated with high potential returns. In other words, the risk-return tradeoff says that invested money can render higher profits only if it is subject to the possibility of being lost
A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities. The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf). The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken. The security market line plots the results of the CAPM for all different risks (betas). Beta is the overall risk in investing in a large market, like the Bombay Stock Exchange. Beta,of an average risk stock as also of the overall market by definition equals 1.0 exactly.
Each company also has a Beta. A company's Beta is that company's risk compared to the Beta (Risk) of the overall market. If the company has a Beta of 3.0, then it is said to be 3 times more risky than the overall market. Beta measures the volatility of the security, relative to the asset class.
Using the CAPM model and the following assumptions, we can compute the expected return of a stock: if the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the expected market return over the period is 10%, the stock is expected to return 17% (3%+2(10%-3%)).
A consequence of CAPM-thinking is that it implies that investing in individual stocks is pointless, because one can duplicate the reward and risk characteristics of any security just by using the right mix of cash with the appropriate asset class. This is why die-hard followers of CAPM avoid stocks, and instead build portfolios merely out of low-cost index funds.
Note! The Capital Asset Pricing Model is a ceteris paribus model. It is only valid within a special set of assumptions. These are:
• Investors are risk averse individuals who maximize the expected utility of their end of period wealth. Implication: The model is a one period model.
• Investors have homogenous expectations (beliefs) about asset returns. Implication: all investors perceive identical opportunity sets. This is, everyone have the same information at the same time.
• Asset returns are distributed by the normal distribution.
• There exists a risk free asset and investors may borrow or lend unlimited amounts of this asset at a constant rate: the risk free rate.
• There is a definite number of assets and their quantities are fixed within the one period world.
• All assets are perfectly divisible and priced in a perfectly competitive market. Implication: e.g. human capital is non-existing (it is not divisible and it can’t be owned as an asset).
• Asset markets are frictionless and information is costless and simultaneously available to all investors. Implication: the borrowing rate equals the lending rate. There are no market imperfections such as taxes, regulations, or restrictions on short selling.
Although the assumptions mentioned above normally are not all valid or met, CAPM remains one of the most used investments models to determine risk and return.
William Sharpe was the 1990 Nobel price winner for Economics "For his contributions to the theory of price formation for financial assets, the so-called Capital Asset Pricing Model (CAPM)."
The risk-return tradeoff could easily be called the iron stomach test. Deciding what amount of risk you can take on is one of the most important investment decisions you will make. The risk-return tradeoff is the balance an investor must decide between the desire for the lowest possible risk for the highest possible returns. Remember to keep in mind that low levels of uncertainty (low risk) are associated with low potential returns and high levels of uncertainty (high risk) are associated with high potential returns.
The risk-free rate of return is usually signified by the quoted yield of "Government Securities" because the government very rarely defaults on loans. Let's suppose that the risk-free rate is currently 6%. Therefore, for virtually no risk, an investor can earn 6% per year on his or her money. But who wants 6% when index funds are averaging 12-14.5% per year? Remember that index funds don't return 14.5% every year, instead they return -5% one year and 25% the next and so on. In other words, in order to receive this higher return investors much also take on considerably more risk.
Let's assume that the risk free rate is 5%, and the overall stock market will produce a rate of return of 12.5% next year. You see that XYZ Ltd. has a beta of 1.7
I f you make a graph of this situation, it would look like this:
• On the horizontal axis are the betas of all companies in the market
• On the vertical axis are the required rates of return, as a percentage
The red line is the Security Market Line.
How did we get it? We plugged in a few sample betas into the equation
Ks = Krf + B ( Km - Krf).
Security --Risk Free--beta=0--k=5%
Overall Stock Market-beta= 1.0--k=12.50%
XYZ Company beta=1.7 k=17.75%
With the stock markets bouncing up and down 5% every week, individual investors clearly need a safety net. Diversifying your Portfolio can work this way and can prevent your entire portfolio from losing value. Diversifying your portfolio may not be the hottest of investment topics. Still, most investment professionals agree that while it does not guarantee against a loss, diversification is the most important component to helping you reach your long-range financial goals while minimizing your risk. Keep in mind, however that no matter how much diversification you do, it can never reduce risk down to zero.
What do you need to have a well diversified portfolio? There are three main things you should do to ensure that you are adequately diversified:
• Your portfolio should be spread among many different investment vehicles such as cash, stocks, bonds, mutual funds, and perhaps even some real estate.
• Your securities should vary in risk.
• You're not restricted to picking only blue chip stocks. In fact, the opposite is true. Picking different investments with different rates of return will ensure that large gains offset losses in other areas. Keep in mind that this doesn't mean that you need to jump into high-risk investments such as penny stocks!
Your securities should vary by industry, minimizing unsystematic risk to small groups of companies.
Another question people always ask is how many stocks they should buy to reduce the risk of their portfolio. The portfolio theory tells us that after 10-12 diversified stocks, you are very close to optimal diversification. This doesn't mean buying 12 internet or tech stocks will give you optimal diversification. Instead, you need to buy stocks of different sizes and from various industries.
