Lesson Objective: To understand the distinction between systematic and firm-specific risk and how diversification can reduce firm-specific risk.

In-Depth Notes:

1. The Two Types of Risk:
Investment risk can be divided into two distinct components:

• Systematic Risk (Market Risk): Risk that affects the entire market and cannot be diversified away. Sources of systematic risk include:

  • Interest Rate Risk: The risk that changes in interest rates will affect the value of investments.

  • Inflation Risk: The risk that inflation will erode the purchasing power of investment returns.

  • Recession Risk: The risk that an economic downturn will negatively impact corporate profits and stock prices.

  • Geopolitical Risk: The risk that political events (e.g., wars, trade disputes) will disrupt markets.

• Unsystematic Risk (Firm-Specific Risk): Risk that is specific to a particular company or industry and can be diversified away. Sources of unsystematic risk include:

  • Business Risk: The risk associated with a company’s operations, such as changes in demand, competition, or input costs.

  • Financial Risk: The risk associated with a company’s use of debt financing.

  • Regulatory Risk: The risk that changes in regulations will affect a company’s profitability.

  • Management Risk: The risk that poor management decisions will negatively impact the company.

2. The Role of Diversification:
Diversification is the process of combining assets in a portfolio to reduce risk. By holding a diversified portfolio, an investor can eliminate unsystematic risk (specific risk). The risk that remains after diversification is systematic risk (market risk), which cannot be eliminated.

• The Number of Securities: As the number of securities in a portfolio increases, the unsystematic risk decreases. Empirical studies have shown that a well-diversified portfolio of 20-30 stocks can eliminate most unsystematic risk.

• The Limits of Diversification: Diversification cannot eliminate systematic risk. Even a highly diversified portfolio is still exposed to market-wide risks.

3. Measuring Systematic Risk:
Systematic risk is measured by beta (β). Beta is a measure of a security’s sensitivity to market movements. Securities with high beta are more sensitive to market movements; securities with low beta are less sensitive.

4. The Risk-Return Trade-Off:
The distinction between systematic and unsystematic risk is central to the risk-return trade-off. Investors are only rewarded for taking on systematic risk, as unsystematic risk can be eliminated through diversification. This is the key insight of the CAPM.