We have been asked by John Stewart, an investment advisor who has recently joined ACG, to help prepare some educational material for a seminar taking place later this month. In this discussion board post, we will be discussing systematic and unsystematic risk as well as a stock’s beta coefficient and how it ties into systematic versus unsystematic risk. Systematic Risk Systematic risk is “associated with market returns and can be attributed to broad factors such as macroeconomic factors” (Faulkenberry, 2012). Macroeconomic factors can be sources of systematic risk.
Some macroeconomic factors that can be sources of systematic risk include changes in the interest rates, currency fluctuations, inflation, civil and political wars, or a recession. A factor that influences the direction and volatility of the entire market is considered to be a systematic risk. A systematic risk “can be partially mitigated by asset allocation” (Faulkenberry, 2012). A portfolio with “different asset classes with low correlation can smooth portfolio returns because asset classes react differently to macroeconomic factors” (Faulkenberry, 2012).
For example, while some of the asset classes are decreasing others can be increasing and vice versa thereby offsetting some of the losses. Unsystematic Risk Unsystematic risk is “company or industry specific risk” (Faulkenberry, 2012). Unlike systematic risk this type of risk can be “attributable or specific to the individual investment or small group of investments” (Faulkenberry, 2012). Unsystematic risk is also known as diversifiable risk or residual risk.
Sources of this type of risk are employee strikes, the outcome of an unfavorable litigation, a natural catastrophe, credit or legal issues, etc. Diversification is a way that this risk can be nearly eliminated. For example, if a portfolio is diversified by having a variety of investments when something negative happens to one of the investments the damage to the portfolio is minimized. Beta Coefficient According to Jenkins (2012), the beta coefficient, or beta, “is a measure of a stock’s risk relative to the whole market”.
The market has a beta of 1. 0. “The individual stocks are ranked according to how much they deviate from the market” (Jenkins, 2012). For example, if a stock moves more than the market then over time that stocks beta is above 1. 0, and if a stock moves less than the market that stocks beta will be less than 1. 0. It is said that high-beta stocks are more risky but there is also a potential for higher returns, and low-beta stocks pose less of a risk but the returns will also be lower.
The stocks “volatility is the amount of uncertainty or risk about the degree of changes in the stock’s value” (Jenkins, 2012). “The higher the volatility means the stock’s value can potentially be spread out over a larger range of values. It also means that the price of that stock can change dramatically over a shorter period in either direction. The lower the volatility means that the stock’s value does not fluctuate dramatically and changes at a steady pace” (Jenkins, 2012). The beta coefficient is a key component of the Capital Asset Pricing Model or CAPM.
This model is used to calculate the cost of equity and describes the relationship between risk and expected returns. Systematic and Unsystematic Risk relationship to the Beta Coefficient As previously stated the beta coefficient is a key component of the capital asset pricing model, which “links the relationship between risk and the expected return of a stock” (Mistakesintrading. com, 2012). The expected rate of return of a stock is the risk-free rate plus a risk premium based on the systematic risk of the stock.
In the CAPM, the risk of a stock or portfolio is broken down into two parts, systematic and unsystematic risk. The risk pertaining to the security itself can be reduced and eliminated through diversification. This risk is known as unsystematic risk, and the remaining risk is systematic risk, “which becomes important in the relationship between risk and return” (Mistakesintrading. com, 2012). When an investor combines a variety of different stocks in the portfolio, the unsystematic risk can be reduced, while the systematic risk remains.
Basically, an increase in diversification of the stock in the portfolio does not eliminate the systematic risk. Conclusion In conclusion, there are a variety of ways a company can minimize or eliminate unsystematic risk to the company’s investment portfolio, however there is little to no way to completely eliminate or minimize the systematic risk. Systematic risk can be partially mitigated by asset allocation, and unsystematic risk can be nearly eliminated by diversification but the risk to investors will almost always remain.
Risk is a part of every business, and if managers and investors are aware of these risks they can begin implementing and managing those risk properly. The risk to the company can be reduced by putting appropriate risk management measures in place to effectively mitigate the risk. This way risk can be controlled, monitored, and properly managed.
Colorado Technical University Online. (2012). Finc605-1204B-01: Corporate portfolio management: Task list: Phase 1 discussion board. Retrieved from https://campus. ctuonline. du/pages/MainFrame. aspx? ContentFrame=/Home/Pages/Default. aspx Faulkenberry, K. (2012). Systematic and unsystematic risk, probability, and expected value. http://arborinvestmentplanner. com/systematic-and-unsystematic-risk-probability-and-expected-value-4/ Jenkins, J. (2012). Understanding the beta coefficient. Retrieved from http://www. investmentu. com/2012/February/beta-coefficient. html Mistakesintrading. com. (2012). Capital asset pricing model. Retrieved from http://www. mistakesintrading. com/wiki-stocks/capital-asset-pricing-model. php