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Understanding Systematic Risk in Finance

The total risk of a portfolio can be split into systematic risk and unsystematic risk. Systematic risk affects a wide range of stocks and cannot be diversified away, while unsystematic risk only affects a few stocks. The Capital Asset Pricing Model (CAPM) is used to determine the compensation an investor should receive for bearing systematic risk, which is measured using beta. Beta reflects how volatile a stock is compared to the overall market. Stocks with betas less than 1 are less volatile than the market, while those above 1 are more volatile. The CAPM helps investors optimize their portfolio's return relative to its systematic risk.

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19 views4 pages

Understanding Systematic Risk in Finance

The total risk of a portfolio can be split into systematic risk and unsystematic risk. Systematic risk affects a wide range of stocks and cannot be diversified away, while unsystematic risk only affects a few stocks. The Capital Asset Pricing Model (CAPM) is used to determine the compensation an investor should receive for bearing systematic risk, which is measured using beta. Beta reflects how volatile a stock is compared to the overall market. Stocks with betas less than 1 are less volatile than the market, while those above 1 are more volatile. The CAPM helps investors optimize their portfolio's return relative to its systematic risk.

Uploaded by

Mutisya Jeffrey
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© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd

Systematic Risk Principle 1

SYSTEMATIC RISK PRINCIPLE

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Systematic Risk Principle 2

Systematic Risk Principle

The total risk of a portfolio can be split into systematic risk and unsystematic risk.

Unsystematic risk does not affect a majority of the stocks, but only a few, hence all assets in a

portfolio do not move identically (either upwards or downwards). Investors are not compensated

for bearing this type of risk as it can be eliminated if one holds large amounts of risky assets in

the portfolios (Ilmanen and Asness, 2011, p. 38). In systematic risk, a wide range of stocks in the

stock exchange are affected by the risk. This type of risk causes all risky assets to move in the

same direction and cannot be diversified away. An investor should expect compensation if they

bear systematic risk. Systemic risks occur as a result of shocks arising from government policy,

acts of nature or international economic forces. An example of a systematic risk is the global

financial crisis of 2008 when no amount of diversification could have prevented stock values

from losing value.

The Capital Asset Pricing Model (CAPM) is used to determine the compensation one

should get for bearing a certain level of systematic risk. In this model, beta is used to measure the

volatility of an asset. It reflects the tendency of a portfolio to respond to shocks in the market.

For instance, stock beta measures the co-movement of the stock return with the market return

where beta is also known as the systematic risk of the stock. If a stock has a beta of less than

1.00, it indicates that the stock has lower volatility compared to the market, which means that the

portfolio is less risky when such a stock is included than without it. An example of stocks with a

low beta value is stocks of companies in the utilities sector, such as water and electric firms,

because they usually move slower compared to market benchmark. A beta value of more than

1.00 indicates that the price of the stock is theoretically more volatile compared to the whole

market. A company whose stock has a beta of 1.10 is assumed to be 10% more volatile
Systematic Risk Principle 3

compared to the market (Jones, 2014). Examples of stocks with a higher beta value compared to

the market average include stocks of technology companies.

As mentioned, the beta of a stock is a measure of how much risk it adds to a portfolio

that is similar to the market. The CAPM model is meant to help investors optimize portfolio

return relative to risk. According to the modern portfolio theory, a portfolio’s expected return

increases when the risk increases (Bodie, Kane, and Marcus, 2017, p. 126). A portfolio that lies

on the capital markets line is preferred over any other that lies right of the line. Theoretically, a

portfolio can be placed on the capital markets line and it would offer the best return for the

investor compared to the amount of risk they are taking. The capital markets line illustrates that

there is a trade-off between increased return and increased risk (Francis and Kim, 2013, p, 450).

Considering it is not possible to have a portfolio that lies perfectly on the capital markets line,

investors usually take too much risk in order to get additional returns.
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Reference List

Bodie, Z., Kane, A. and Marcus, A. (2017). Essentials of investments. : New York: NY McGraw-

Hill Education.

Francis, J. and Kim, D. (2013). Modern portfolio theory. Hoboken, N.J.: J. Wiley & Sons.

Ilmanen, A. and Asness, C. (2011). Expected returns. Chichester, West Sussex: John Wiley &

Sons.

Jones, C. (2014). Investments: Principles and Concepts. Hoboken, NJ: Wiley.

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