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MESSAGE 2: MARKET RISKS ARE MACRO RISKS

We have seen that diversified portfolios are not exposed to the unique risks of individual stocks but are exposed to the uncertain events that affect the entire securities market and the entire economy. These are macroeconomic, or macro, factors such as changes in interest rates, industrial production, inflation, foreign exchange rates, and energy costs. These factors affect most firms earnings and stock prices. When the relevant macro risks turn generally favorable, stock prices rise and investors do well; when the same variables go the other way, investors suffer. You can often assess relative market risks just by thinking through exposures to the business cycle and other macro variables. The following businesses have substantial macro and market risks:

Airlines. Because business travel falls during a recession, and individuals postpone vacations and other discretionary travel, the airline industry is subject to the swings of the business cycle. On the positive side, airline profits really take off when business is booming and personal incomes are rising.

Machine tool manufacturers. These businesses are especially exposed to the business cycle. Manufacturing companies that have excess capacity rarely buy new machine tools to expand. During recessions, excess capacity can be quite high. Here, on the other hand, are two industries with less than average macro exposures:

Food companies. Companies selling staples, such as breakfast cereal, flour, and dog food, find that demand for their products is relatively stable in good times and bad.

Electric utilities. Business demand for electric power varies somewhat across the business cycle, but by much less than demand for air travel or machine tools. Also, many electric utilities profits are regulated. Regulation cuts off upside profit potential but also gives the utilities the opportunity to increase prices when demand is slack.

Remember, investors holding diversified portfolios are mostly concerned with macroeconomic risks. They do not worry about microeconomic risks peculiar to a particular company or investment project. Micro risks wash out in diversified portfolios. Company managers may worry about both macro and micro risks, but only the former affect the cost of capital.

MESSAGE 3: RISK CAN BE MEASURED

United Airlines clearly has more exposure to macro risks than food companies such as Kellogg or General Mills. These are easy cases. But is IBM stock a riskier investment than Exxon? That s not an easy question to reason through. We can, however, measure the risk of IBM and Exxon by looking at how their stock prices fluctuate.

We ve already hinted at how to do this. Remember that diversified investors are concerned with market risks. The movements of the stock market sum up the net effects of all relevant macroeconomic uncertainties. If the market portfolio of all traded stocks is up in a particular month, we conclude that the net effect of macroeconomic news is positive. Remember, the performance of the market is barely affected by a firm- specific event. These cancel out across thousands of stocks in the market.

How do we measure the risk of a single stock, like IBM or Exxon? We do not look at the stocks in isolation, because the risks that loom when you re up close to a single company are often diversifiable. Instead we measure the individual stock s sensitivity to the fluctuations of the overall stock market.