pension fund—for manylarger and even midsize publicly
traded companies.
1 Institutional investors tendto be diversified, though the
degree of diversification can vary across different investors.
Theargumentthat themarginalinvestoriswelldiversified
becomes tenuous when looking at smaller, less traded
companies as well as some closely held firms and can
completely break down when looking at small private
businesses.Later in this chapter, weconsider howbest to
modifyconventionalriskandreturnmodelstoestimatecosts
of equity for these firms.
Inthelongterm,wewouldarguethatdiversifiedinvestors
willtendto pushundiversified investorsout ofthemarket.
Afterall,theriskinaninvestmentwillalwaysbeperceivedto
behigherforanundiversifiedinvestorthanforadiversified
one,sincethelatterdoesnotshoulderanyfirm-specificrisk
and the former does. If both investors have the same
expectationsaboutfutureearningsandcashflowsonanasset,
thediversifiedinvestorwillbewillingtopayahigherprice
forthatassetbecauseofhisorherperceptionoflowerrisk.
Consequently,theasset,overtime,willendupbeingheldby
diversified investors.
Models Measuring Market Risk
While mostconventionalriskand returnmodelsinfinance
agreeonthefirstthreestepsoftheriskanalysisprocess(i.e.,
thatriskcomesfromthedistributionofactualreturnsaround
theexpectedreturnandthatriskshouldbemeasuredfromthe
perspectiveof amarginalinvestor whoiswelldiversified)
theypartwayswhenitcomestomeasuringnondiversifiable