When High Risk is Not High Return_2

Posted in CFA, finance by qmarks on March 11, 2010

On a previous post about firm valuation we have mentioned that firms investing in riskier project not necessarily expect high returns because the risk can be diversified anyway. Only taking systematic risk (market risk, un-diversifiable risk) should bring higher return to investor which is gauged by Beta. How can we apply this thesis to portfolios?

One important conclusion of capital market theory is that equilibrium security returns depend on a stock’s or a portfolio’s systematic risk, not its total risk as measured by standard deviation. One of the assumptions of the model is that diversification is free. The reasoning is that investors will not be compensated for bearing risk that can be eliminated at no cost. If you think about the costs of a no-load index fund compared to buying individual stocks, diversification is actually very low cost if not actually free.

The implications of this conclusion are very important to asset pricing. The riskiest stock with risk measured as standard deviation of returns does not necessarily have the greatest expected return. Consider a biotech stock with one new drug product that is in clinical trials to determine its effectiveness. If it turns out that the drug is effective and safe, stock returns will be quite high. If on the other hand the subjects in the clinical trials are killed or otherwise harmed by the drug, the stock will fall to approximately zero and returns will be quite poor.  This describes a stock with high standard deviation of returns (i.e. high total risk)

The high risk of our biotech stock, however is primarily from firm-specific factors, so its unsystematic risk is high. Since market factors such as economic growth rates have little to do with the eventual outcome for this stock, systematic risk is a small proportion of the total risk of the stock. Capital market theory says that the equilibrium return on this stock may be less than that of a stock with much less firm-specific risk but more sensitivity to the factors that drive the return of the overall market. An established manufacturer of machine tools may not be a very risk investment in terms of total risk, but may have a greater sensitivity to market (systematic) risk factors such as GDP growth rates than our biotech stock. Given this scenario the stock with more total risk (biotech stock) has less systematic risk and will therefore have a lower equilibrium rate of return according to capital market theory.

Note that holding many biotech firms in a portfolio will diversify away the firm specific risk. Some will have blockbuster produts and some will fail. but you can imagine that when 50 or 100 stocks are combined into a portfolio, the uncertainty about the portfolio return is much less than the uncertainty about the return of a single biotech firm stock.

To sum up unsystematic risk is not compensated in equilibrium because it can be eliminated for free through diversification. Systematic risk is measured by contiribution of a security to the risk of a well diversified portfolio and the expected equilibrium return on an individual security will depend on its systematic risk.

source: CFA Portfolio Management Notes

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