At several points in the alt investment section I see quotes like this: “each investment has a large idiosyncratic (unsystemic) risk component, which can provide moderate diversification.” what??? Are we just throwing MPT out the window here? Why not just load up on concentrated stock positions too.
I thought the whole idea of diversification was to get exposure to priced risk factors and minimize unsystematic risk. That quote above was above Private Equity which has a very high correlation with public stock.
I had this book next to me so I actually looked it up. The correlation between Private Equity and publicly traded shares is actually “moderately high”. Per CFAI, the fact that PE has a higher idiosyncratic risk than publicly traded shares means that this correlation cannot be extremely high. Hence it can play a moderate role in risk diversification (though more people look to it for long term return enhancement than risk diversification). Makes sense I think.
If they are saying that the unsystematic risk is just a secondary benefit of going after increase returns then it makes more sense to me. If they are saying that unsystematic risk is a way to get diversification then I am not sure what the heck I learned at level I and II. Thanks for looking it up sv.
No Problem 
i dont have Schweser so I dont know what it says. But the CFAI book does not make it sound like “high unsystemic risk = diversification”. It sounded more like a. "A relatively higher unsystemic risk = less than perfect correlation and hence some diversification b. It *could* play a role in diversification, but that is not what investors look to PE for. (So more like a side-benefit)
That’s really helpful, thanks sv.
high unsystematic risk = greater diversification potential b/c unsystematic risk can be diversified away. on the other hand, if an investment is already diversified (low unsystematic risk), then there’s no benefit of adding that portfolio b/c there’s no room for diversification manipulation
Idiosyncratic refers to a peculiar/unique characteristic. Therefore large idiosyncratic risk implies a risk which is very individualistic to the asset resulting in very little correlation with other assets. When such an asset is combined with other asssets (a portfolio) it would provide diversification benefits.
I know that idiosyncratic risk is unique (unsystematic), but I don’t get why we are trying to capture it. At level I and II we learned that you only want exposure to priced risk factors. Unsystematic risk, by definition, is not a priced risk factor. The fact that it can be diversified away is a testament to that fact. On AVERAGE you don’t get rewarded for taking these risk. I just found it odd that we were always told to get rid of the evil unsystematic risk and then it pops up here as an advantage.
mwvt9 Wrote: ------------------------------------------------------- > I know that idiosyncratic risk is unique > (unsystematic), but I don’t get why we are trying > to capture it. > > At level I and II we learned that you only want > exposure to priced risk factors. Unsystematic > risk, by definition, is not a priced risk factor. > The fact that it can be diversified away is a > testament to that fact. On AVERAGE you don’t get > rewarded for taking these risk. > > I just found it odd that we were always told to > get rid of the evil unsystematic risk and then it > pops up here as an advantage. mwvt9: as my previous post, it’s an advantage b/c it can be diversified away to enhance return.
Every asset has a unique risk associated with itself…If any (other) asset has large idiosyncratic risk component which acts in a manner that is opposite to idiosyncratic(unsystematic) risk of other assets, it helps you to reduce unsystematic risk at portfolio level… the point I am trying to drive here is - Investor will not be rewarded for taking high unsystematic risk at portfolio level however he will be rewarded for taking high idiosyncratic risk at individual asset level (in such a manner that it reduces the overall unsystematic risk at portfolio level). Also, it may be appropriate to look at word ‘idiosyncratic risk’ relevant only for individual asset and not portfolio unlike unsystematic risk which can be used at individual asset level as well as portfolio.
Unsystematic PORTFOLIO risk is bad, because it can be diversified away for “free” by adding more securities. Unsystematic risk among the individual components of your portfolio is necessary. Regarding new securities that you add - if they have only systematic risk, they won’t help to diversify the portfolio as much. So add to your portfolio multiple securities/asset classes that have a lot of non-systematic risk and are non-correlated. So you want your PORTFOLIO to exhibit no unsystematic risk. You want the individual SECURITIES within your portfolio to exhibit plenty of non-correlated, unsystematic risk so that their movements offset each other. If you are adding a new position to your portfolio, and that portfolio is already diversified so it has mostly systematic risk, adding a position that is essentially exposed to the same risks as your portfolio will not help. You get more bang for your diversification buck for adding a position that is exposed to different risk factors.