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MARKET RISK VERSUS UNIQUE RISK

Our examples illustrate that even a little diversification can provide a substantial reduction in variability. Suppose you calculate and compare the standard deviations of randomly chosen one-stock portfolios, two-stock portfolios, five-stock portfolios, and so on. You can see from Figure 3.18 that diversification can cut the variability of returns by about half. But you can get most of this benefit with relatively few stocks: the improvement is slight when the number of stocks is increased beyond, say, 15. Figure 3.18 also illustrates that no matter how many securities you hold, you cannot eliminate all risk. There remains the danger that the market including your portfolio will plummet. The risk that can be eliminated by diversification is called unique risk. The risk that you can t avoid regardless of how much you diversify is generally known as market risk or systematic risk.

Unique risk arises because many of the perils that surround an individual company are peculiar to that company and perhaps its direct competitors. Market risk stems from economywide perils that threaten all businesses. Market risk explains why stocks have a tendency to move together, so that even well-diversified portfolios are exposed to market movements.

Figure 3.19 divides risk into its two parts unique risk and market risk. If you have only a single stock, unique risk is very important; but once you have a portfolio of 30 or more stocks, diversification has done most of what it can to eliminate risk.

Thinking about Risk

How can you tell which risks are unique and diversifiable? Where do market risks come from? Here are three messages to help you think clearly about risk.

MESSAGE 1: SOME RISKS LOOK BIG AND DANGEROUS BUT REALLY ARE DIVERSIFIABLE

Managers confront risks up close and personal. They must make decisions about particular investments. The failure of such an investment could cost a promotion, bonus, or otherwise steady job. Yet that same investment may not seem risky to an investor who can stand back and combine it in a diversified portfolio with many other assets or securities.

Wildcat Oil Wells

You have just been promoted to director of exploration, Western Hemisphere, of MPS Oil. The manager of your exploration team in far-off Costaguana has appealed for $20 million extra to drill in an even steamier part of the Costaguanan jungle. The manager thinks there may be an elephant field worth $500 million or more hidden there. But the chance of finding it is at best one in ten, and yesterday MPS s CEO sourly commented on the $100 million already wasted on Costaguanan exploration. Is this a risky investment? For you it probably is; you may be a hero if oil is found and a goat otherwise. But MPS drills hundreds of wells worldwide; for the company as a whole, it s the average success rate that matters. Geologic risks (is there oil or not?) should average out. The risk of a worldwide drilling program is much less than the apparent risk of any single wildcat well.

Back up one step, and think of the investors who buy MPS stock. The investors may hold other oil companies too, as well as companies producing steel, computers, clothing, cement, and breakfast cereal. They naturally and realistically assume that your successes and failures in drilling oil wells will average out with the thousands of independent bets made by the companies in their portfolio.

Therefore, the risks you face in Costaguana do not affect the rate of return they demand for investing in MPS Oil. Diversified investors in MPS stock will be happy if you find that elephant field, but they probably will not notice if you fail and lose your job. In any case, they will not demand a higher average rate of return for worrying about geologic risks in Costaguana.

UNIQUE RISK Risk factors affecting only that firm. Also called diversifiable risk.

MARKET RISK Economywide (macroeconomic) sources of risk that affect the overall stock market. Also called systematic risk.

Fire Insurance

Would you be willing to write a $100,000 fire insurance policy on your neighbor s house? The neighbor is willing to pay you $100 for a year s protection, and experience shows that the chance of fire damage in a given year is substantially less than one in a thousand. But if your neighbor s house is damaged by fire, you would have to pay up.

Few of us have deep enough pockets to insure our neighbors, even if the odds of fire damage are very low. Insurance seems a risky business if you think policy by policy. But a large insurance company, which may issue a million policies, is concerned only with average losses, which can be predicted with excellent accuracy.