Investors are not rewarded for taking on unsystematic risk, which is the risk that is specific to a particular company or industry. This is because unsystematic risk can be diversified away by investing in a wide range of stocks. For example, if an investor invests in a portfolio of 100 stocks, the risk of any one stock losing value is greatly reduced. Systematic risk, on the other hand, is the risk that affects the entire market, such as a recession or a war. Systematic risk cannot be diversified away, but investors can reduce their exposure to it by investing in bonds or other less risky assets.
Diversifying Unsystematic Risk
Unsystematic risk refers to the risk inherent in a specific company or industry, as opposed to the broader market. While investors cannot eliminate unsystematic risk entirely, they can reduce its impact on their portfolios through diversification.
- Invest in multiple companies in different industries: By doing so, investors can reduce their exposure to any single company or industry’s performance.
- Invest in index funds or exchange-traded funds (ETFs): These funds typically track a broad market index, such as the S&P 500, and provide instant diversification across many companies.
- Consider international diversification: Investing in foreign markets can further reduce unsystematic risk, as economic factors and industry risks may vary across countries.
Summary Table
| Investment Type | Diversification |
|---|---|
| Single Company | Low |
| Multiple Companies in Same Industry | Medium |
| Multiple Companies in Different Industries | High |
| Index Fund/ETF | Very High |
| International Diversification | Highest |
The Efficient Market Hypothesis and Unsystematic Risk
The Efficient Market Hypothesis (EMH) is a theory that states that the prices of stocks and other assets reflect all available information, meaning that it is impossible to consistently outperform the market by buying and selling stocks.
The EMH is based on the premise that there are two types of risk: systematic risk and unsystematic risk. Systematic risk is the risk that affects the entire market, such as economic downturns or interest rate hikes. Unsystematic risk is the risk that is specific to a particular company or industry, such as a product recall or a change in consumer preferences.
According to the EMH, investors cannot be rewarded for taking on unsystematic risk. This is because the prices of stocks already reflect this risk.
| Type of Risk | Description | Can Investors Be Rewarded? |
|---|---|---|
| Systematic Risk | Risk that affects the entire market | No |
| Unsystematic Risk | Risk that is specific to a particular company or industry | No |
However, investors can be rewarded for taking on systematic risk. This is because the prices of stocks do not always fully reflect this risk, and investors can earn a premium for bearing it.
- Systematic risk is often referred to as “beta” risk.
- Beta measures the volatility of a stock’s price relative to the volatility of the overall market.
- A stock with a beta of 1 is as volatile as the overall market.
- A stock with a beta of less than 1 is less volatile than the overall market.
- A stock with a beta of more than 1 is more volatile than the overall market.
Risk Premiums and Unsystematic Risk
Investors are compensated for bearing risk through risk premiums. A risk premium is the additional return that an investor expects to receive for taking on a particular risk. The higher the risk, the higher the risk premium.
Unsystematic risk is the risk that is specific to a particular company or industry. This type of risk can be diversified away by investing in a portfolio of different stocks. Investors are not rewarded for taking on unsystematic risk because it can be diversified away.
Systematic risk is the risk that affects the entire market. This type of risk cannot be diversified away. Investors are rewarded for taking on systematic risk because it cannot be diversified away.
- Systematic risk: Affects the entire market and cannot be diversified away.
- Unsystematic risk: Specific to a particular company or industry and can be diversified away.
| Type of Risk | Can be Diversified Away? | Investors Rewarded? |
|---|---|---|
| Systematic | No | Yes |
| Unsystematic | Yes | No |
And there you have it, folks! The relationship between unsystematic risk and returns can be a bit of a head-scratcher, but hopefully, this article has shed some light on the matter. Remember, it’s not always the risks you can’t see that make you money. Sometimes, it’s the risks that are right under your nose. Keep exploring, keep learning, and keep your eyes on the prize. Thanks for reading, and be sure to drop by again soon for more financial insights. Until then, stay curious and keep investing!