Introduction to Corporate Finance

6: The Trade-Off Between Risk and Return

As you can see, there are diminishing returns to diversification. Adding more securities to this portfolio

would lower the portfolio’s volatility. But even if the portfolio contains every available security in the market,

the standard deviation will not drop much more (recall that the standard deviation of the entire market is

a little less than 20%). Diversification reduces volatility, but only up to a point. No matter how diversified

the portfolio is, there will still be some volatility remaining. In finance, the risk that remains even in a well-

diversified portfolio is called systematic risk.^14 The term systematic risk refers to a risk that occurs systematically

across many different shares. Examples of systematic risks include the recession/expansion phases of the

macroeconomy, as well as changes in inflation, interest rates and exchange rates. On 11 September 2001,

and in the days that followed, US investors learned that terrorism is a type of systematic risk, as the vast

majority of shares fell in response to the attacks on the World Trade Center and the Pentagon.

Look again at the point in Figure 6.8 showing the standard deviation of a portfolio containing just

one security. The standard deviation here is about 55%, which is a little lower than the standard deviation

for the average share trading in the US market. If this security’s standard deviation equals 55%, but the

standard deviation of a portfolio containing this security (and many other assets) is roughly 20%, this

suggests that most of an individual security’s risk disappears once we put that security inside a portfolio.

A substantial fraction of the volatility of an individual security vanishes when investors hold the security

as part of a diversified portfolio. The risk of an individual security that disappears when one diversifies is

called unsystematic risk.^15 As the name implies, unsystematic risks are those risks which are not common

to many securities. Instead, unsystematic risks affect just a few securities at a time.

To understand the difference between systematic and unsystematic risk, consider the defence

industry. Suppose the government announces that it will spend billions of dollars on a new, high-tech

weapons system. Several defence contractors submit bids to obtain the contract for this system. Investors

know that each of these contractors has some chance of winning the bid, but they don’t know which

company will prevail in the end. Before the government awards the contract, investors will bid up the

prices of all defence shares, anticipating that for each company there is some chance of winning the bid.

However, once the government announces the winning bidder, that company’s share price will rise even

more, while the prices of other defence shares will fall.

An investor who places an all-or-nothing bet by buying shares in only one defence contractor takes

a lot of risk. Either the investor will guess the outcome of the bidding process successfully and the

investment will pay off handsomely, or the investor will bet on the wrong company and lose money.

Instead, suppose the investor diversifies and holds a position in each defence company. That way, no

matter which company wins the contract, the investor will be sure to have at least a small claim on the

value of that deal. By diversifying, the investor eliminates the unsystematic risk in this situation. However,

suppose there is a chance that the defence department will cancel its plans to build the weapons system.

When that announcement is made, all defence industry share prices will fall, and diversifying across all

of these companies will not help an investor avoid that loss.^16

14 Other terms used to describe this type of risk are non-diversifiable risk and market risk. The meaning of non-diversifiable risk is self-evident.
Market risk conveys the sense that we are concerned with risks that affect the broad market, not just a few stocks or even a few sectors in
the market
15 Unsystematic risk is sometimes called diversifiable risk, unique risk, company-specific risk or idiosyncratic risk. Each of these terms implies
that we are talking about risks that apply to a single company or to a few companies, not to many companies simultaneously, so this type of
risk can be eliminated by holding a diversified portfolio.
16 A clever reader might argue that if the government spends less on defence, then more is spent on something else. So an investor may be able
to diversify this risk away by holding a broad portfolio of securities rather than just a portfolio of defence shares. In that case, our illustration
is once again about unsystematic rather than systematic risk.

systematic risk

Risk that cannot be eliminated

through diversification

unsystematic risk

Risk that can be eliminated

through diversification

JUtpal Bhattacharya,

Indiana University

‘The cost of equity goes

up if insider trading laws

are not enforced.’

See the entire interview on

the CourseMate website.

Source: Cengage Learning

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