In the previous entry, I discussed how diversification can reduce an organization’s specific risks and mentioned that diversification cannot influence overall systemic, or market, risks.
Imagine we have a highly diversified portfolio. Despite this, the portfolio cannot be entirely risk-free as its returns will still fluctuate based on the overall macroeconomic environment. This range of fluctuation is the systemic, or market risk, of a well-diversified portfolio.
Market risk also applies to individual stocks and is measured by the β (beta) coefficient. Beta reflects the sensitivity of a specific stock to overall market conditions. Simply put, beta shows how much a stock’s value changes in response to a 1% change in the market index.
The interesting point is that the weighted average beta of selected stocks determines the portfolio’s beta. One of the fundamental findings in financial science is that the market risk of a well-diversified portfolio depends on the market risk of its individual components.
The image below shows how the risks of different portfolios can vary despite the degree of diversification. When well-diversified, the portfolio is directly exposed to market risk.
If the weighted average beta is between 0 and 1, the portfolio’s risk is lower than the market risk. If it is 1, it is equal to the market risk, and if it is higher than 1, the portfolio’s risk is higher than the market risk. It is also worth noting that some companies have negative betas.
To measure beta, historical statistical analysis is used to determine the relationship between a specific stock’s price and the overall market fluctuations. However, this relationship is not perfectly linear, as companies exhibit specific risks. But the average figure obtained through regression is considered stable over the years, assuming the organization does not undergo radical changes (such as moving to a different sector or country, adopting revolutionary innovations, etc.).
P.S.
We can create a portfolio with almost zero market risk. Imagine a large ship anchored and unaffected by ocean waves. While possible, our goal is not to eliminate risk but to maximize expected returns per unit of risk. Therefore, a risk-free portfolio does not equate to a desirable portfolio.
The image is from this book:
Principles of Corporate Finance, by Richard Brealey, Stewart Myers, and Franklin Allen
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