Systematic Risk Principle 1

SYSTEMATIC RISK PRINCIPLE

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 Systematic Risk Principle 2

Systematic Risk Principle

The total risk of a portfolio can be split into systematic risk and unsystematic risk.
Unsystematic risk does not affect a majority of the stocks, but only a few, hence all assets in a
portfolio do not move identically (either upwards or downwards). Investors are not compensated
for bearing this type of risk as it can be eliminated if one holds large amounts of risky assets in
the portfolios (Ilmanen and Asness, 2011, p. 38). In systematic risk, a wide range of stocks in the
stock exchange are affected by the risk. This type of risk causes all risky assets to move in the
same direction and cannot be diversified away. An investor should expect compensation if they
bear systematic risk. Systemic risks occur as a result of shocks arising from government policy,
acts of nature or international economic forces.An example of a systematic risk is the global
financial crisis of 2008 when no amount of diversification could have prevented stock values
from losing value.
The Capital Asset Pricing Model (CAPM) is used to determine the compensation one
should get for bearing a certain level of systematic risk. In this model, beta is used to measure the
volatility of an asset. It reflects the tendency of a portfolio to respond to shocks in the market.
For instance, stock beta measures the co-movement of the stock return with the market return
where beta is also known as the systematic risk of the stock. If a stock has a beta of less than
1.00, it indicates that the stock has lower volatility compared to the market,which means that the
portfolio is less risky when such astock is included than without it. An example of stocks with a
low beta value is stocks of companies in the utilities sector, such as water and electric firms,
because they usually move slower compared to market benchmark. A beta value of more than
1.00 indicates that the price of the stock is theoretically more volatile compared to the whole
market. For instance, beta of Apples stock is 1.15 (MarketWatch.com, 2019). It can, therefore, be
assumed that the firm’s 15 % more volatile compared to the market (Jones, 2014). Examples of
stocks with a higher beta value compared to the market average include stocks of technology
companies.
As mentioned, the beta of a stock is a measure of how much risk it adds to a portfolio that
is similar to the market. The CAPM model is meant to help investors optimize portfolio return
relative to risk. According to the modern portfolio theory, a portfolio’s expected return increases
when the risk increases (Bodie, Kane, and Marcus, 2017, p. 126). A portfolio that lies on the
capital markets line is preferred over any other that lies right of the line. Continuing with the
 Systematic Risk Principle 3

example of Apple stock, it lies above the security market line, an indication that its risk is higher
than the market risk premium. Theoretically, a portfolio can be placed on the capital markets line
and it would offer the best return for the investor compared to the amount of risk they are taking.
The capital markets line illustrates that there is a trade-off between increased return and
increased risk i.e. the risk to reward ratio (Francis and Kim, 2013, p, 450). Considering it is not
possible to have a portfolio that lies perfectly on the capital markets line, investors usually take
too much risk in order to get additional returns. For example Reeves (2018), listed ford as one of
the companies with high risk-high reward stocks due to the recent disastrous IPO. However, with
more than 180 million users per day, zero debt, and $ 2 billion in the bank, the company’s stock
has potential to appreciate significantly despite short term troubles.
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References
Bodie, Z., Kane, A. and Marcus, A. (2017). Essentials of investments. : New York: NY McGraw-
Hill Education.
Francis, J. and Kim, D. (2013). Modern portfolio theory. Hoboken, N.J.: J. Wiley & Sons.
Ilmanen, A. and Asness, C. (2011). Expected returns. Chichester, West Sussex: John Wiley &
Sons.
Jones, C. (2014). Investments: Principles and Concepts. Hoboken, NJ: Wiley.
MarketWatch.com (2019). Apple Inc.. [online] MarketWatch. Available
at: https://www.marketwatch.com/investing/stock/aapl [Accessed 11 Jan. 2019].
Reeves, J. (2018). 5 high-risk, high-reward stocks to buy on the stock market’s dive. [online]
MarketWatch. Available at: https://www.marketwatch.com/story/5-high-risk-high-
reward-stocks-to-buy-on-the-stock-markets-dip-2018-02-02[Accessed 11 Jan. 2019].