Return and RISK
The term return refers to income from a security after a defined period either in the form of
interest, dividend, or market appreciation in security value. On the other hand, risk refers to
uncertainty over the future to get this return. In simple words, it is a probability of getting return
on security.
Risk Explained
There are many ways to define risk. However, in the context of financial management and
investing, it can be defined as either the probability of losing ‘X’ amount of an investment over a
given time period or as the return volatility of an investment over a given time period.
When an investor considers purchasing a very high-risk investment, they should expect to lose
some or possibly even all their investment. For example, if an investor owns shares (stock) in a
high-risk company and that company goes bankrupt, they are likely to lose all of their
investment.
Return volatility is typically defined by standard deviation. This statistical figure measures the
dispersion of a dataset relative to its mean, calculated as the square root of the variance.
Standard deviation is usually applied to an investment’s annual return to gauge return volatility.
A greater standard deviation indicates greater investment volatility and, therefore, greater risk.
Return Explained
A return (also referred to as a financial return or investment return) is usually presented as a
percentage relative to the original investment over a given time period. There are two commonly
used rates of return in financial management.
1. Nominal rates of return that include inflation
2. Real rates of return that exclude inflation
An investment return can come in a wide range of forms, including capital
gains, interest, dividends, or rental income in the case of real estate. Again, these investment
returns are usually presented as a percentage. In its simplest form, nominal investment returns
can be calculated using three variables:
1. The initial investment
2. The ending value of investment
3. The investment time period
Systematic risk is measured by a stock's beta. A company's beta is the company's risk sensitivity
to the market as a whole. A beta of 1 means the stock moves with the market. A beta over 1
means the stock is more volatile than the market.
Systematic risk is defined as the inherent risk that affects the market, not just one sector of the
market. This type of risk is uncontrollable by any company and is usually derived from
macroeconomic factors. Systematic risk can't be diversified away since it affects the entire
market. Systematic risk is measured by a stock's beta. A company's beta is the company's risk
sensitivity to the market as a whole. A beta of 1 means the stock moves with the market. A beta
over 1 means the stock is more volatile than the market. A beta of less than 1 means the stock is
less volatile than the market. An investor can calculate his expected return by multiplying the
return of the market by the stock's beta. An example of systematic risk is COVID-19. It affects
all companies and can't be diversified away.
Expected return = beta * market return
Unsystematic risk, or company-specific risk, is a risk associated with a particular investment.
Unsystematic risk can be mitigated through diversification, and so is also known as diversifiable
risk. Once diversified, investors are still subject to market-wide systematic risk.
Despite the barrage of different terms, they all fundamentally mean the same thing. Unsystematic
risk is a risk that investors can do something about. It’s a risk that investors can control to some
extent.
It’s a risk that an investor can diversify away by holding a diversified portfolio.
From a company’s standpoint, it’s a risk that affects the company, but not necessarily its
competitors.
Examples of Unsystematic Risk
Examples of unsystematic risk or idiosyncratic risk include (but aren’t limited to):
death of the founder/CEO, especially if no succession plans exist
fire, theft, or other damage to the business or property
accounting scandals
fraudulent activities
incompetent management or staff
poor internal training programs
Unsystematic Risk is specific to particular company or security. Systematic Risk is
measured through the beta of the stock with reference to the market and this beta is
calculated by regression analysis or methods. Unsystematic Risk is caused due to
internal or controllable factors.
Systematic Risk Unsystematic Risk
Affects the entire market or economy Specific to a particular industry, sector, or
company
Cannot be eliminated through diversification Can be reduced or eliminated through
diversification
Arises from external factors beyond an investor'sArises from internal factors specific to a
control company or sector
Examples include inflation, recession, or interest
Examples include management issues or product
rate risk recalls
Cannot be eliminated through prudent Can be mitigated through careful analysis and
investment decisions research
Often referred to as market risk Also known as idiosyncratic risk
Diversification does not lower its impact Diversification helps reduce its impact
Measured by beta coefficient Measured by alpha coefficient
Impacts the entire portfolio Impacts only specific investments within a
portfolio
Can lead to losses in both bull and bear markets Mostly affects investments during unfavorable
conditions
Now that you know what is unsystematic risk and how it differs from systematic risk, let’s think
about how to calculate unsystematic risk.
Calculating unsystematic risk is fairly straightforward. It fundamentally relies on the fact that
Total Risk is made up of:
Systematic Risk, and
Unsystematic Risk
Put differently, we can say:
Total Risk = Systematic Risk + Unsystematic Risk
With this interpretation of total risk, we can simply rearrange to obtain an expression for
Unsystematic Risk. Thus we can calculate unsystematic risk as…
Unsystematic Risk = Total Risk – Systematic Risk
Yes, this is a conceptual formula for unsystematic risk, but don’t worry – we’ll go over the exact
formula to calculate unsystematic risk further down.
