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Risk, Market Sensitivity, and Diversification

William F. Sharpe

he notion of risk is central to both security depends on the extent to which its price is sensi-
T analysis and portfolio selection. The primary
source of risk for an individual security is uncer-
tive to market swings. Our first measure is in-
tended to quantify this relationship.
tainty about its future price. And the primary The non-market risk of a portfolio depends to
source of risk for a portfolio is uncertainty about its a considerable extent on its diversification. Our
future market value. second measure is intended to quantify this rela-
Clearly, some securities are riskier than oth- tionship. It is designed so that two portfolios with
ers, and some portfolios are riskier than others. comparable "diversification" will be likely to have
Moreover, the riskiness of a portfolio is related to comparable amounts of non-market risk.
the riskiness of the securities it contains. Few
would quarrel with these statements. To go far-
ther, however, one must adopt quantitative mea- MARKET SENSlTIVFFY
sures. This paper describes two such measures. When there is a major change in the market, it is a
The first, market sensitivity, (or "beta"), has been rare security indeed that does not go along, to a
advocated by a number of authors z and is being greater or lesser extent. A market swing generally
used increasingly within the investment commu- results when investors change their opinions
nity. 2 The second measure, portfolio diversification, about the future of the economy. Some companies
attempts to make more precise a notion that has are affected more by such changes than are others.
been used for a great many years. In terms of price action, some securities are more
In the remaining sections we will argue: (1) sensitive to market changes than are others. It is a
that much is to be learned about the risk of a relatively simple matter to express this relationship
portfolio by measuring its market sensitivity and quantitatively. Consider the following statement:
diversification, (2) that such measures can be cal-
culated simply, using corresponding measures for If the market goes up one per cent more than expected, the
the securities in the portfolio, and (3) that straight- price of XYZ will be percentgreater than expected.
forward analysis of past data can lead to values of
such measures for securities that will prove useful The number used to fill in the blank can be defined
in this process. as XYZ's market sensitivity. If the value is less than
1.0, the security is defensive--it moves less than
MARKET AND NON-MARKET RISK the typical stock in market swings. On the other
To begin, it is important to divide risk into two hand, if the market sensitivity is greater than 1.0,
important, but quite different, components. Why the security is aggressive--it moves more than a
is it difficult to predict the future price of a secu- typical stock in market swings.
rity? Partly, because it is difficult to predict the It is possible to define a number of such
future level of the overall market. This source of measures: one for a one percent increase in the
risk can be termed the security's market risk. But market, one for a one percent decrease, one for a
even if the future course of the market were two percent increase, etc. But this would add little
known, some risk would remain. The price of a but complexity. It is common practice to use one
security depends at least partly on the fortunes of number, with the accompanying assumption that
the issuer--independent of the course of the mar- the percentage change in the price of a security
ket or overall economy. This source can be termed from its expected value is most likely to equal its
the security's non-market risk. market sensitivity times the percentage change in
The market risk of a security or portfolio the market from its expected value.
The market sensitivity of a portfolio is simply
the weighted average of the market sensitivities of
Reprinted from Financial Analysts Journal (January~February its component securities, using the relative values
1972):74-79. as weights. 3 Table 1 provides an example.

84 Financial Analysts Joumal / January-February 1995

1995, AIMR

Table 1. Calculation of a Porffolio's EslJmated Market Sensil~y

Current Number of Current Estimated Relative Value
Market Price Shares in Market Relative Market times Market
Security Per Share Portfolio Value Value Sensitivity Sensitivity
ABC $13.00 1,000 $13,000 .325 .80 .26
DEF 50.00 300 15,000 .375 1.20 .45
GHI 30.00 400 12,000 .300 1.30 .39
$40,000 1.000 1.10
Portfolio Estimated
Market Sensitivity

DIVERSIRCA'RON rifles, each from a different industry. This type of

W h y d o i n v e s t m e n t m a n a g e r s advocate at least difference is difficult to capture in a simple for-
some diversification w h e n constructing a portfo- mula. But differences in relative holdings and
lio? Because it can r e d u c e risk. More precisely: securities' n o n - m a r k e t risks can be a c c o m m o d a t e d
because it can r e d u c e n o n - m a r k e t risk. W h e n one quite easily.
security does worse t h a n expected (given the mar- The first step requires an estimate of each
ket's overall behavior), a n o t h e r is likely to do security's n o n - m a r k e t risk, relative to that of a
better than expected. And, generally, the more typical security. A value of 1.0 indicates that a
securities in a portfolio, the greater the likelihood security is typical in this respect. A value of .5
that sufficient good fortune will a p p e a r to balance indicates that it has half as m u c h n o n - m a r k e t risk
off the bad fortune. as a typical security. A value of 2.0 indicates it has
But it is not quite that simple. The n u m b e r of twice as much, etc.
securities in a portfolio provides a fairly crude Once such estimates have b e e n obtained, it is
measure of diversification. Imagine twO portfolios, easy to estimate the effective diversification of the
each with ten securities. Portfolio A's funds are portfolio. Table 2 provides an example.
divided equally a m o n g its ten securities, but half of As the table shows, a n u m b e r of values m u s t
portfolio B's f u n d s are invested in a single security. be a d d e d t o g e t h e r - - o n e for each security. Each
Portfolio A w o u l d seem to be m o r e diversified than value is calculated b y squaring the p r o d u c t of (1)
portfolio B. To further complicate the matter, some the relative value invested in the security times (2)
securities have m o r e n o n - m a r k e t risk than others. its relative n o n - m a r k e t risk. The s u m (.371 in this
A portfolio of ten securities, each of which has a example) is t h e n divided into 1.0 to d e t e r m i n e the
large a m o u n t of this type of risk, is likely to offer portfolio's diversification. In this case, it is 2.70.
less effective diversification than a n o t h e r with ten Table 3 provides some insight into the mean-
securities, each of w h i c h has a small a m o u n t of ing of this measure.
n o n - m a r k e t risk. Each security listed in Table 3 provides an
There are other considerations. For example, a equal p r o p o r t i o n of the portfolio's market value;
portfolio of ten chemical securities is likely to offer moreover, each security is typical with respect to
less effective diversification than one of ten secu- n o n - m a r k e t risk. A n d the effective diversification

Table 2. Calculation of a Portfolio's Diversification

Market Number of Current (V) (R) Relative
Price Per Shares in Market Relative Non-Market
Security Share Portfolio Value Value Risk VxR (V X R) 2

ABC $13.00 1,000 $13,000 .325 0.5 .163 .027

DEF 50.00 300 15,000 .375 1.0 .375 .141
GHI 30.00 400 12,000 .300 1.5 .450 .203
$40,000 1.000 .371
Diversification = . ~ = 2.70

Financial Analysts Joumal / January-February 1995 85


Table 3. Diversification of an Evenly Balanced Rgure 1. The Effect of Diversilicalion on Non-

Portfolio of Typical Securities Market Risk
(V) (R) Relative
o ~" 100
Relative Non-Market
Security Value Risk Vx R (V X R) 2
- 75
A .2 1.0 .2 .04
B .2 1.0 .2 .04
C .2 1.0 .2 .04 ~.~ 50
D .2 1.0 .2 .04
E .2 1.0 .2 .04
1.0 .20 ~ 25

1 z~
Diversification = ~ - = 5.0 0 I I I I I I
.2O 10 20 30 40 50 60 70
Portfolio Diversification

of the portfolio is 5.0. Thus a portfolio of five

typical stocks, each representing an equal propor- sification of 4.00 is likely to have 50 percent as
tion of overall market value, has a calculated m u c h risk as one with a diversification of 1.00. 4
diversification of 5.0. The basis for this relationship, a n d the choice
This example illustrates the interpretation of of the measure of diversification itself, is described
the diversification measure: in the appendix. Here we concentrate on a more
A balanced portfolio with a diversification of X will have as
practical question: h o w should the n e e d e d values
m u c h n o n - m a r k e t risk as a balanced portfolio of X securities, for individual securities be estimated?
each with a typical a m o u n t of n o n - m a r k e t risk, and each w o r t h
an equal dollar a m o u n t at current market prices. The term ESTIMATES FOR SECURmES
" b a l a n c e d " is included to rule out portfolios with heavy con- Two values are required for every security in a
centrations of similar securities. Such portfolios will generally
be less diversified than indicated by the calculation described
portfolio: the security's market sensitivity a n d its
here---i.e., they will have more non-market risk. relative non-market risk. H o w can such estimates
be obtained? The problem does not differ in a n y
In cases such as that s h o w n in Table 2, where significant w a y from that of estimating, say, future
a r o u n d n u m b e r is not obtained for diversification, earnings per share. Careful analysis of past data,
the result can be interpreted as lying b e t w e e n two expert knowledge about the firm a n d the industry,
alternatives. Thus a portfolio with a diversification interviews with m a n a g e m e n t , s t u d y of investor
of 2.70 is less diversified than a portfolio of three psychology--all these ingredients can be brought
typical securities held in equal proportions; but it is to bear on the problem. But this m a y provide
more diversified t h a n one of two typical securities, accuracy that costs more t h a n it is worth. It is
held in equal proportions. important to remember that the values obtained
for individual securities are to be combined to
DIVERSlRCA'RON AND NON-MARKET RISK calculate comparable values for a portfolio. A n d
The non-market risk of a portfolio will, of course, the accuracy of a portfolio estimate is far more
d e p e n d on more than its calculated level of diver- important t h a n the accuracy of the individual se-
sification. However, it is possible to provide a set curity estimates.
of benchmarks for portfolios which have been A n u m b e r of rather inaccurate estimates for
designed to avoid u n d u e concentrations of similar securities m a y combine to form an exceptionally
securities. Figure I shows the general relationship. accurate estimate for a portfolio, thanks to the law
The vertical axis measures non-market risk relative of large numbers. The estimate for one security
to that of a typical security. Thus a portfolio with a m a y be too high, a n d another too low, with the
diversification of 1.0 has a full 100 percent of such result that the average is "just right." To borrow
risk. the statistician's jargon: if predictions about secu-
As diversification increases, the a m o u n t of rities are subject to error but unbiased, s predictions
non-market risk can be expected to decrease, but about fairly well-diversified portfolios m a y be
not proportionately. Thus a portfolio with a diver- quite accurate.

86 Financial Analysts Joumal/ January-February 1995


This suggests the possibility of using past data months. Then each month is plotted and a straight
exclusively to obtain estimates of the relevant at- line fit through the points (either visually or via
tributes of securities. Figure 2 provides an example. statistical methods). The slope of this line is the
security's market sensitivity.
A useful measure of relative non-market risk
Figure 2. Estimating Market S ~ v i t y from Past can also be obtained from past data. First, the
Data statistician's "standard error" is calculated for the
security. 6 Roughly, this is the vertical distance
Changein from the line in a diagram such as Figure 2 within
Price of which two-thirds of the points fall. After the stan-
the Security
dard error has been calculated, it is divided by the
standard error for a typical security. 7 The result is
a measure of the security's relative non-market risk.

11.8% Several firms produce estimates of market
sensitivity on a continuing basis. Methods differ,
as do names ("beta" and "volatility" are quite
Percentage common). The most accessible source is V a l u e L i n e ,
S&P500 w h i c h covers 1400 securities. Some brokerage
houses provide coverage of even more (e.g.; Mer-
rill Lynch provides estimates for over 3000 stocks
M a r k e t S e n s i t i v i t y = 0.8 with monthly updating). At present, values of
relative non-market risk are not quite as accessible.
However, Merrill Lynch provides values from
which they can be readily computed, and uses
them in the manner described here.
No two measures can tell all there is to know
For each of 60 months, the percentage change about a po~tfolio's risk. But the relatively simple
in Standard and Poor's 500-stock index is deter- measures presented here can greatly increase
mined. This represents the overall "market." one's understanding of the characteristics of a
Next, the percentage change in the price of the portfolio. It behooves the thoughtful analyst to
security in question is calculated for each of the 60 make such calculations.


This paper uses standard statistical measures of ci = the difference between the return on se-
variation to represent risk. The risk of a security is curity i and that predicted by its relation-
measured by a standard deviation: ship with the Overall market
tri = the standard deviation of Ri T h e risk of the security thus depends on two
Ri = the rate of return on security i components:
= the percentage price change plus divi-
dend yield O-i2 = bi2orm 2 + O-ci21
The rate of return on a security is assumed to equal
its yield plus a linear function of the percentage where
change in the overall market:
bi2o'm 2 = the market risk of security i
Ri -- Yi + ai + biRm + ci, o"m the standard deviation of R m

O'c2, = the non-market risk of security i

o-c, = the standard deviation of c i
Yi = the dividend yield on security i
ai = some constant If the values of the cis for various securities are
bi = the market sensitiyity of security i independent of one another and of the overall
Rm = the percentage change in the overall level of the market 8 the risk of a portfolio will also
market depend on two components:

Financial Analysts Journal / January-February 1995 87


% = the s t a n d a r d d e v i a t i o n of Rp (the rate of
r e t u r n o n the portfolio)
bp = t h e m a r k e t sensitivity of t h e portfolio T h e n o n - m a r k e t risk relative to t h a t of a typical
= EXib i s e c u r i t y is this a m o u n t d i v i d e d b y Crc:, or
Xi = the p r o p o r t i o n of the portfolio's value 1
invested in security i
The term representing the n o n - m a r k e t risk of the
portfolio can be modified to form the measure of This is the r e l a t i o n s h i p p l o t t e d in F i g u r e 1.
diversification advocated in the text. Let o'c. repre- A n i n t e r p r e t a t i o n of the m e a s u r e of diversifi-
sent a n y more or less arbitrarily chosen "typical" cation is p r o v i d e d b y c o n s i d e r i n g a portfolio of n
level of o'ci. T h e n , stocks, e a c h typical w i t h r e s p e c t to n o n - m a r k e t
risk, a n d e a c h w o r t h t h e s a m e dollar v a l u e . In
0" ./2 other words,
EXi2orci 2 = Orc . 2 E X i 2 v c'

i i \ O'el
ri = r2 = = rn = 1,
T h e t e r m in p a r e n t h e s e s measures a security's
relative n o n - m a r k e t risk:
Xi = Xz . . . . . X. = -.
r i = the relative n o n - m a r k e t risk of s e c u r i t y i
= o'c,O'c. Obviously,
Diversification is d e f i n e d in t h e text as follows: 1 1
1 D = E(xiri)2 = 1 1 1
~ ( X i r i ) 2" i n-~+~ + . . . +. n 2
so t h a t

Exi =o-c. .

If the v a l u e s of the cis are i n d e p e n d e n t , a portfolio
We take as a specific m e a s u r e of the non- w i t h a diversification of D will t h u s h a v e t h e s a m e
market risk of a portfolio the standard error of its a m o u n t of n o n - m a r k e t risk as o n e w i t h D typical
r e t u r n . But this is s i m p l y t h e s q u a r e r o o t of the stocks, h e l d in e q u a l p r o p o r t i o n s (as a s s e r t e d in
sum: t h e text).

1. See W.F. Sharpe, "A Simplified Model for Portfolio Analy- the estimate of the portfolio's market sensitivity. In statistical
sis," Management Science (January 1963):277-93; Sharpe, Port- terms: the standard error of beta is smaller, the smaller the
folio Theory and Capital Markets (New York: McGraw-Hill, standard deviation of the residual.
1970); J.L. Treynor, "How to Rate Management of Invest- 5. And the errors are uncorrelated.
ment Funds," Harvard Business Review (January/February 6. See Sharpe, Portfolio Theory and Capital Markets.
1965):63-75; and Treynor, W.W. Priest, Jr., L. Fisher, and
7. E.g., the median or average value of the standard errors for
C.A. Higgins, "Using Portfolio Composition to Estimate
Risk," Financial Analysts Journal (September/October 1968): a representative cross-section of securities.
93-100. 8. This assumption, which has been widely employed, should
2. C. Welles, "'The Beta Revolution: Learning to Live with prove acceptable in most cases. For further discussion, see
Risk," The Institutional Investor (September 1971):21-64. K.J. Cohen and J.A. Pogue, "An Empirical Evaluation of
3. See Sharpe, Portfolio Theory and Capital Markets. Alternative Portfolio Selection Models," The Journal of Busi-
4. Well-diversified portfolios have another advantage. In gen- ness (April 1967):166-93, and Sharpe, Portfolio Theory and
eral, the greater the diversification, the more accurate will be Capital Markets.

88 Financial Analysts J o u m a l / January-February 1995