This section discusses diversification and the impact of diversification on risk and return. Unsystematic risk addresses the impact of diversification on risk and return. Systematic risk evaluates the effect of diversification on risk and return. These concepts are used as corporations manage their investment portfolios and seek to achieve the best returns possible, given existing market conditions.
Impact of Diversification on Risk and Return: Systematic Risk
Systematic risk is intrinsic to the market, and thus diversification has no effect on its presence in investments.
Describe how systemic risk influences the stock market
- Diversification is a technique for reducing risk that relies on the lack of a tight positive relationship among the returns of various types of assets.
- The role of diversification is to narrow the range of possible outcomes.
- Unsystematic risk does not factor into an investment's risk premium, since this type of risk can be diversified away.
- systematic risk
systematic or non-diversifiable risk is a term given to the portion of risk in a portfolio that cannot be diversified away by holding a pool of individual assets and therefore commands a return in excess of the risk-free-rate.
Recall that previously we talked about the security market line and the implication that investors require more compensation for extra risk. One might pay the same amount for a safe investment as for an investment carrying more risk; however, the riskier investment will, in theory, provide a higher return. This is the principle behind the security market line . Diversification is a technique for reducing risk that relies on the lack of a tight positive relationship among the returns of various types of assets. By diversifying a portfolio of assets, an investor loses the chance to experience a return associated with having invested solely in a single asset with the highest return. On the other hand, the investor also avoids experiencing a return associated with having invested solely in the asset with the lowest return -- sometimes even becoming a negative return. Thus, the role of diversification is to narrow the range of possible outcomes.
The Security Market Line: Diversification theory says that the only risk that earns a risk premium is that which can't be diversified away.
As a result, the portion of risk that is unsystematic -- or risk that can be diversified away -- does not require additional compensation in terms of expected return. For example, consider the case of an individual who buys 50 corporate bonds from a single company. The individual receives a certain yield based on the purchase price. However, if unexpected business risks lead to liquidity problems, the company might go bankrupt and default on its loans. In such a case, the investor will lose the entirety of the investment. Conversely, if the investor buys a single bond from 50 different corporations who have similar credit ratings, then one instance of insolvency will have a far less drastic effect on the investor's portfolio.
Now, imagine that these 50 corporations are all given a lesser credit rating because of the risk of their overall market segment. In this case, the individual is still at risk to lose some or all of the initial investment. This type of risk cannot be diversified away, and is referred to as systematic risk. This is the portion of risk that pays the risk premium, because the risk associated with this particular segment of the market is more tightly linked to the risk of the market as a whole. This risk is present regardless of the amount of diversification undertaken by an investor.