If you have read the article Systematic & unsystematic risk you should be aware that a firm faces two types of risk. However as an investor we a re only concerned with one type of risk: Systematic risk. In this article I will explain why investors are not interested in unsystemctic risk and I will introduce a variable used to calculate the systematic risk of a company.
Unsystematic risk is unimportant as it may be eliminated through diversification. Unsystematic risk relates to risk that is unique to one firm. For example the return of an icecream company would be positively correlated to sunlight hours and negatively correlated to rainfall volume. By contrast, while the return of an umbrella manufacturer would be negatively correlated to sunlight hours and positively correlated to rainfall hours. The theory explains that if we are able to hold a wide range of (preferably negatively correlated) companies. We can eliminate the unique risk relating to the individual stocks. For example if we held an icream company and an umbrella company, the portfolio would more or less be unaffected by sunlight and rainfall hours.
Therefore if an individual investor can simply eliminate unsystematic risk simply by diversifying then as an investor we should only demand a return relating to systematic risk. In other words, if we do not diversify, we are assuming additional risk (unsystematic) without any extra compensation or return.
How do we measure the systematic risk of comapny?
The systematic risk of a company is determined by the capital asset pricing model. For more information on this formula click here. The important variable that I will introduce in this article is Beta. Beta measures the sensitivity of a stocks returns with that of the market. It calculates this by first plotting daily/weekly or monthly returns over a large period of time. Along the horizontal axis is the return of the market, and along the vertical axis is the return of the particular stock. Next we determine the line of best fit. The gradient of this line is known as beta. Therefore if beta is 1 we would say the sytematic risk of the stock is equal to the market. If the beta is greater then one, we would say the volatility/return of the stock is greater then the market. Finally if the beta is less then one, we would say the volatility/return of the stock is less then the market.