Weshouldnotethattheexpectedreturnsandvariancesthat
we see in practice arealmost always estimatedusing past
returns ratherthanexpectedfuturereturns. Theassumption
wearemakingwhenwedothisisthatpastreturnsaregood
indicatorsoffuturereturndistributions.Whenthisassumption
isviolated,asisthecasewhentheasset’scharacteristicshave
changedsignificantlyovertime,thehistoricalestimatesmay
not be good measures of risk.
Step 2: Diversifiable and Nondiversifiable Risk
Although there are many reasons that actual returns may
differfromexpectedreturns,wecangroupthereasonsinto
twocategories:firm-specificandmarketwide.Therisksthat
arise from firm-specific actions affect one or a few
investments,whiletheriskarisingfrommarketwidereasons
affectmanyorallinvestments.Thisdistinctioniscriticalto
the way we assess risk in finance.
Withinthefirm-specificriskcategory,wewouldconsidera
widerangeofrisks,startingwiththeriskthatafirmmayhave
misjudgedthedemandforaproductfromitscustomers;we
call this project risk. The risk could also arise from
competitorsprovingtobestrongerorweakerthananticipated;
wecallthis competitiverisk.Infact,wewould extendour
riskmeasurestoincluderisksthatmayaffectanentiresector
butarerestrictedtothatsector;wecallthissectorrisk.What
iscommonacrossthesethreerisks—project,competitive,and
sectorrisk—isthattheyaffectonlyasmallsubsetoffirms.
Thereisotherriskthatismuchmorepervasiveand affects
manyifnotallinvestments.Forinstance,wheninterestrates
increase, all investments are affected, albeit to different
degrees.Similarly,whentheeconomyweakens,allfirmsfeel