PART 2: VALUATION, RISK AND RETURN
a two-step process. The first step is to define what we mean by risk and to measure it, and the second
step is to quantify how much return we should expect on an asset with a given amount of risk.Measuring the risk of a single asset
Recall that Chapter 6 introduced the notions of systematic and unsystematic risk. Remember these
concepts:■ Systematic risks simultaneously affect many different securities, whereas unsystematic risks affect
just a few securities at a time. Systematic risk refers to events, such as unexpected changes in the
overall health of the economy, interest rate movements or changes in inflation. Events that we
classify as examples of unsystematic risk include the failure of a company’s new product to gain
market share, a scandal involving top management at a particular company or the loss of a key
employee.^7■ Investors can eliminate unsystematic risk by diversifying, but diversification cannot eradicate systematic
(or market) risk. Because it is easy for investors to shed one type of risk but not the other, the market
pays investors for bearing systematic risk. That is, assets with more exposure to systematic risk generally
offer investors higher returns than assets with less exposure to systematic risk. We see evidence
of that proposition in the historical record, such as the higher long-term average return on shares
compared to Treasury bonds or Treasury notes.■ The standard deviation of an asset’s returns measures how much returns fluctuate around
the average. The standard deviation calculation makes no distinction between a movement in
returns caused by systematic factors, such as an increase in oil prices, and movements associated
with unsystematic factors, such as the outcome of a product liability lawsuit filed against one
company. In other words, the standard deviation measures an asset’s total risk, equal to the sum
of its systematic and unsystematic components. Because only the systematic component of risk
influences an asset’s expected return, an asset’s standard deviation is an unreliable guide to its
expected return.
If systematic risk means risk that affects the entire market, then for an individual share, we need to know
the extent to which the share moves when the market moves. We need a measure that captures only
the systematic component of a share’s volatility, because only that component should be related to the
asset’s expected return. When an event having a positive (or negative) effect on the overall market also
has a pronounced positive (or negative) effect on a particular share, then that share has a high degree of
systematic risk and should also have a high expected return.
A key aspect of this approach is assessing the behaviour of the entire market. Since we cannot
observe the entire market (remember that many assets are not listed, making price information difficult
to obtain), we need to use a proxy to estimate its behaviour. We can do this by using a market index. We
use the S&P/ASX 200 Index as a proxy for the Australian market.
The S&P/ASX 200 Index covers 200 of the largest listed Australian shares, by market capitalisation.
This represents approximately 80% of the Australian equity market capitalisation. Figure 7.1 shows the
characteristics of this index. It shows how the market is heavily skewed towards financial and resource
shares.7 Notice that all these examples are negative events, in the sense that we expect them to cause the company’s share price to fall. Of course,
risk means that outcomes can be surprisingly good, just as they can be surprisingly bad.