Systematic and Unsystematic Risk

The objective of portfolio diversification is the selection of investment opportunities that reduce total portfolio risk without compromising overall return. The preceding analysis based on Markowitz efficiency and Tobin's Separation Theorem in perfect capital markets indicates that:

If the standard deviation (risk) of an individual investment is higher than that of the portfolio in which it is held, then part of the standard deviation must have been diversified away through correlation with other portfolio constituents.

A high level of diversification results in rational investors holding the market portfolio, which they will do in combination with lending or borrowing at the risk-free rate. This leaves only the element of risk that is correlated with the market as a whole. In other words portfolio risk equals market risk, which is undiversifiable

To clarify this point for future analysis, Figure 4.3 summarizes the relationship between total risk and its component parts where.

Total risk is split between:

- Systematic or market risk, so called because it is endemic throughout the system (market) and is undiversifiable. It relates to general economic factors that affect all firms and financial securities, and explains why share prices tend to move in sympathy.

- Unsystematic risk, sometimes termed specific, residual, or unique risk, relates to specific (unique) economic factors, which impact upon individual industries, companies, securities and projects. It can be eliminated entirely through efficient diversification.

In terms of our earlier analysis, systematic risk measures the extent to which an investment's return moves sympathetically (systematically) with all the financial securities that comprise the market portfolio (the system). It describes a particular portfolio's inherent sensitivity to global political and macro-economic volatility. The best recent example, of course, is the 2007 financial meltdown and subsequent economic recession. Because individual companies or investors have no control over such events, they require a rate of return commensurate with their relative systematic risk. The greater this risk, the higher the rate of return required by those with widely diversified portfolios that reflect movements in the market as a whole.

The Inter-relationship of Risk Concepts

Figure 4.3: The Inter-relationship of Risk Concepts

In contrast, unsystematic risk relates to an individual security's price or even a project and is independent of market risk. Applied to individual companies, it is caused by micro-economic factors such as the level of profitability, product innovation and the quality of financial management. Because it is completely diversifiable (variations in returns cancel out over time) unsystematic risk carries no market premium. Thus, all the risk in a fully diversified portfolio is market or systematic risk.

You may have encountered systematic risk elsewhere in your studies under other names. For example, Figure 4.3 reveals that systematic risk comprises a company's business risk and possibly financial risk. Certainly if you have read the author's other SFM texts, you will recall that business risk reflects the unavoidable variability of project returns according to the nature of the investment (investment policy). This may be higher or lower than that for other projects, or the market as a whole. Systematic risk may also reflect a premium for financial risk, which arises from the proportion of debt to equity in a firm's capital structure (gearing) and the amount of dividends paid in relation to the level of retained earnings, (financial policy). Of course, there is considerable empirical support for the view that financial risk is irrelevant based on the seminal work of Modigliani-Miller (1958 and 1961) explained in SFM. Irrespective of whether financial policies matter, for the moment all we need say is that for all-equity firms with full dividend distribution policies, there is an academic consensus that business risk equals systematic (market) risk and is not diversifiable.

Review Activity

Given our analysis of Markowitz efficiency and the Separation of Tobin, briefly summarise the implications for optimum portfolio management?

Summary and Conclusions

Markowitz, explains how investors or companies can reduce risk but maintain their return by holding more than one investment providing their returns are not positively correlated. This implies that all rational investors will diversify their risky investments into a portfolio.

Tobin illustrates how the introduction of risk-free investments further reduces portfolio risk, using the CML to define a new frontier of efficient portfolios.

Consequently, all investors are capable of eliminating unsystematic risk by expanding their investment portfolios until they reflect the market portfolio.

Based on numerous studies, Figure 4.4 highlights the empirical fact that up to 95 percent of unsystematic risk can be diversified away by randomly increasing the number of investments in a portfolio to about thirty. With one investment, portfolio risk is represented by the sum of unsystematic and systematic risk, i.e. the investment's total risk as measured by its standard deviation. When the portfolio constituents reach double figures virtually all the risk associated with holding that portfolio becomes systematic or market risk. See Fisher and Lorie (1970) for one of the earliest and best reviews of the phenomenon.

Portfolio Risk and Diversification

Figure 4.4: Portfolio Risk and Diversification

It should therefore come as no surprise that without to-days computer technology and software to solve their problems:

Academic and financial analysts of the 1960's, requiring a much simpler model than that offered by Markowitz to enable them to diversify efficiently, were quick to appreciate the work of Tobin and the utility of the relationship between the systematic risk of either a project, a financial security, or a portfolio and their returns.

Selected References

1. Markowitz, H.M., "Portfolio Selection", The Journal of Finance, Vol. 13, No. 1, March 1952.

2. Tobin, J., "Liquidity Preferences as Behaviour Towards Risk", Review of Economic Studies, February 1958.

3. Fisher, I., The Theory of Interest, Macmillan (London), 1930.

4. Modigliani, F. and Miller, M.H., "The Cost of Capital, Corporation Finance and the Theory of Investment", American Economic Review, Vol. XLVIII, No. 4, September 1958.

5. Miller, M.H. and Modigliani, F., "Dividend Policy, Growth and the Valuation of Shares", Journal of Business of the University of Chicago, Vol. 34, No. 4, October 1961.

6. Fisher, L. and Lorie, J., "Some Studies of Variability of Returns on Investment in Common Stocks", Journal of Business, April 1970.

7. Hill, R.A.,

- Strategic Financial Management, 2009.

- Strategic Financial Management; Exercises, 2009.

- Portfolio Theory and Financial Analyses; Exercises, 2010.

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