Really simple question: Is Beta classified as nonsystematic (diversifiable) risk or systematic risk (market)?
I always thought that it was nonsystematic. For example, if you have a portfolio with mining stocks (beta of 2.5, let’s say) you could diversifiable some of that away by having “safe” stocks such as bank stocks. Then portfolio beta would decrease.
If beta is market risk, this really threw me off while I was doing reading 44 EOC.
The total risk of an asset can be decomposed into systematic (non diversifiable) risk and non-systematic (diversifiable) risk.
diversifiable risk is the component of total risk that can be be eliminated through portfolio diversification or holding a collection of assets which are less than perfectly positively correlated (less than +1 correlation) with each other. Since the investor can eliminate this risk component, he will not be rewarded for taking on this risk when making investments.
non diversifiable risk is the component of total risk that affects all assets in one way or another (war,inflation,politics) hence you cannot eliminate it through diversification. The market will reward the investor for assuming systematic risk.
The CAPM beta is a measure of systemtic risk with respect to market movements in the sense that general market movements affect all assets in one way or another, generating a risk that cannot be removed through diversification, and hence demands compensation that scales with exposure.
Hence we have CAPM : rf + beta*[E(Rm)-rf]
beta*[E(Rm)-rf] is the risk premium that the market provides to the investor for assuming systematic risk. The more sensitive the asset return is to general market movements,the greater is beta,the greater the compensation or risk premium.
If beta were a measure of non-systematic risk,as you thought, then it would not appear in the CAPM because its effects on portfolio risk can be diversified away.
The beta of a portfolio is simply the weighted average of all betas associated with the assets in that portfolio. So you can reduce portfolio beta by combining asset1 with beta=2 and asset2 with beta= -1 .This is somewhat different from the diversification argument.
When you want to reduce portfolio beta, you want to find assets that when combined into a portfolio would reduce the systematic risk (average portfolio Beta).
When you want to diversify a portfolio, you want to find assets that when combined into a portfolio would eliminate non systematic risk.
In the former case you are reducing portfolio beta. In the latter case you are reducing portfolio risk by eliminating non-systematic risk. Hence reducing systematic risk (portfolio beta) by combining various assets into a portfolio should NOT be confused with diversification.
Hope this helps.
Thanks that did help. Just let me clarify one thing:
When you say this, do you mean to use the word “reduce” because you can’t fully eliminate non-systematic risk? Once the portfolio has 12-30 stocks, systematic risk would still remain, right?
Systemic risk (Beta) will still remain even once you have diversifiied all the non-systemic (company) risk.
From your perspective, a portfolio of c20 stocks will mean nil non-systemic risk.
yeah i suppose you could theoretically eliminate it but practically you would just reduce it rather than eliminate it outright (citation needed)
A picture paints a thousand words though!
Systematic risk is like cockroaches, death, and taxes. It has always been there, and it will always be there, for ever and ever amen.
IE - if you see that a person says “We can eliminate our sytematic risk”, then you know they are full of it. (This is true at least for Level 1. Later, you’ll find that you can use long-short strategies to eliminate it, but that’s a Level 3 topic.)
CFA curriculum Volume 6, Reading 66, at the bottom of P175,
It is stated under the “Absolute Return” : … theoretically, betas of funds using absolute return strategies should be close to zero.
Can anyone explain why theoretically, betas of funds using absolute return strategies should be close to zero ?
The dudes operating the absolute strategies may short.
According to CAPM, the expected return is risk-free rate if beta is zero. Then what is the purpose of absolute return strategies ?
The purpose is to provide a return over the RFR obviously. If I own Pepsi and I am short Coke, and lets assume they have equal betas (or I adjust my capital to achieve a beta adjusted exposure of zero), then theoretically you’d say I should return the RFR. However, there is nonsystematic risk that remains to drive a return. For instance, if Pepsi thrives due to a new product or coke is hit with a negative news story, there’s opportunity for gains over the RFR. This is a market neutral approach, where beta is close to zero but you can take on no systematic risk. In essence, you take on only risk you want, but you do so expecting alpha due to your selection. Make sense?
Bear in mind that when you see the graph that says that you can eliminate unsystematic risk by having 30 stocks in a portfolio, that doesn’t mean that any old 30 stocks will do: they have to be 30 stocks carefully chosen so that their correlations of returns are quite low, and their company specific (unsystematic) risks offset each other.
What do these scenarios mean ? Beta > 1 or <1 ?
I know that Beta = 1 means the unsystematic risk is completely diversified away.
Does Beta > 1 means some unsystematic risks are still existing ?
And Beta < 1 means some negative unsystematic risks are existing ?
I think you need to reread the section, because you are all sorts of wrong. What you think you know you do not. Not trying to be a dick here, but you have this pretty messed up and should re-read whatever LOS this is in, and a couple more times thru it will probably do wonders on a concept that is relatively important.
Thanks for your response ! Sorry, I reread the relevant section in the text and I am still confused.
By definition, for a market portfolio (for example, if we take S&P 500 as the market portfolio, as in CFAI text), the beta shall be 1 and all the non-systematic (unsystematic) risks is diversified away and only the systematic (market) risk is remained. The expected return for a market portfolio is expected market return calculated as : Rf + 1x [E(Rm)-Rf] = E(Rm).
For other portfolios other than S&P 500, if beta > 1 (for example beta = 1.2 for a portfolio) , is it that there are still some non-systematic risks existing (1.2 – 1.0 = 0.2) in the portfolio which are not completely diversified away (relatively to S&P 500) ? Otherwise, its beta will be 1 (as S&P 500) ?
Would you please kindly advise what’s wrong with me ? Thanks !
Try looking at it like this:
The S&P500 beta is 1. The beta of an individual stock, lets say Wells Fargo (WFC) is 1.36; So all this really is is sensitivity to the market. Thats why the S&P is 1, cuz it is 100% sensitive to itself. All others are compared to their market, so WFC would be 136% as sensitive to movements in the S&P. If the S&P goes up 1%, you’d expect WFC to go up 1.36%. This is not due to anything non-systematic at WFC, just its past sensitivities. This should jive with your CAPM equation, where the only variable that changes is Beta, and thus kicks out a different expected return.
For stocks with B>1, you cannot say that the amount over 1 is nonsystematic risk. Each stock has its own level of systematic risk, which is measured by the beta equation and dependent on the dispersion of past returns. At the end of the day, Beta measures systematic risk, the risk you cannot diversify away. Therefore, it if is 1.5 then it is 1.5, and all that risk is systematic non-diversifiable risk of owning that security.
The non-systematic risk is going to be a portion of any individual security, of which there may be many (ie-headlines, drug approval, M&A, etc). This is not measured by Beta. These risks can be reduced by holding a larger number of individual securities. As noted previously, the larger the number and differentiated the risks among those securities the different the impact on reducing non-systematic portfolio risk. Its as simple as realizing that holding all your money in a biotech name carries a lot of risk if a drug isnt approved, where the stock may go to $0. Therefore, maybe you buy a utility stock, a bank stock, etc…now the risk of the drug approval isn’t such a big deal to your overall portfolio…(oversimplification and generalizations realized)
This last sentence needs a little clarification.
It does not mean that if the return on the S&P 500 is 1%, then the (expected) return on WFC is 1.36%. (In fact, without more information we cannot compute the expected return on WFC.)
What it means is that if the return on the S&P 500 changes by 1%, then the (expected) change in WFC’s return will be 1.36%. So, if last year the S&P 500 returned 5%, and this year it returns 6.5%, we would expect that this year’s return on WFC will be 1.5% × 1.36 = 2.04% higher than last year’s return on WFC, whatever that was.
According to CAPM/SML, this would be: RFR+B(MKT return - RFR)…assume RFR=0 (which is not worth argument right now) and MKT return is the S&P of 1%, then the E® of WFC with a B=1.36 would equate to 1.36% return. So I am not sure what additional info you require to compute the expected return.
I agree with your second paragraph, which is a bit more robust than my example and shows that what looks linear with a RFR=0 doesnt hold in all scenarios and the point is that this is a measure of sensitivity ot change.
You nailed it: you need to know the risk-free rate.
Just think of regression coefficients, then the interpretation of beta as sensitivty drops out quite literally.
Thank you for your responses ! I am still confused by following issues.
Why a portfolio (say, a portfolio comprising only stocks of banking industry) has a beta of 1.2 (just for discussion) or an individual stock (say, Dell Computer) has a beta of 1.6 (just for discussion), rather than 1 ? Do these mean that there are some specific (non-systematic) risks inherent in the portfolio or the stock, relatively to S&P 500 which has a beta of 1 ?
For the portfolio comprising only stocks of banking industry, are the specific (non-systematic) risks those risks inherent in the banking industry ? For Dell Computer, are the specific (non-systematic) risks those risks inherent in Dell Computer itself as well as those risks inherent in the computer industry ? Is it that a portfolio of USD 1 billion and comprises all 500 stocks (market-value weighted) in S&P 500 shall have a berta of 1 ?
Your advices will be appreciated !