Risk and return:
Risk and return are two key factors influencing investment decisions. These two words are highly and positively correlated with each other. In fact, there is a most popular finance principle that says, “ higher the risk higher the return”. As a basic rule as well, an investor always expects a higher return when the investment risk is higher.
When Investors invest in the business, they expect a return. Meanwhile, they face an investment risk as well. For instance, in the case of investment in equity shares, the risk for an investor could be:
- The liquidation of a company, or
- Fluctuations of company profits, or
- Dividends might fall as compared to the previous year.
A few types of investments are riskier than others because of the nature of the industry and markets. For instance, IT Business is riskier than supermarket business. Now, let’s come to the point. Why does an investor expect a higher return on high risky investment? Well, the answer is very simple and straightforward. When you invest in a highly risky business, then returns are less predictable or more volatile, and therefore the expected returns should be higher to compensate for the higher business risk.
Diversification to reduce risk
Diversification is the strategy of investing in a large number of investments in order to reduce the overall risk to the entire portfolio. In other words, an investor can reduce the volatility of expected returns by diversifying his investments and holding a portfolio of different investments.
The underlying reason why diversification is typically effective in minimizing risk is just because of this popular saying, “Don’t put all your eggs in one basket.”
When an investor’s portfolio consists of only one investment, for instance, one stock, then if anything awful happens to that stock, the investor’s entire investment will suffer intensely. So, creating a portfolio of different investments can reduce the variance and standard deviation of returns from the total portfolio, because if some investments provide a lower-than-expected return, others will provide a higher-than-expected return. Extremely high or low returns are therefore less likely to occur in this case. Thus, diversification reduces the overall risk.
While diversification can minimize a portfolio’s risks, it cannot eliminate them entirely. In fact, the investor has created a well-diversified portfolio, even if there exists an investment risk that cannot be eliminated by diversification. In this case, economists divide an individual investment’s overall risk into two components: Diversifiable risk and non-diversifiable risk.
Diversifiable risk (Unsystematic risk)
It’s a risk that is specific to a given investment and it can be eliminated by diversification. In a well-diversified portfolio, the unsystematic risk is zero. Hence, Investors are not required any additional return to compensate them for unsystematic risk.
Creating a well-diversified portfolio is still one of the best strategies as this minimizes diversified risk at one end.
Non-diversifiable risk (Systematic risk, or market risk)
This type of risk can not be eliminated even with the diversification of the investment portfolio. We also call it systematic or market risk because it is an inevitable part of the economy. In fact, it is highly affected by the business cycle.
When the economy is in the boom, business profits are rising and almost all stocks are doing well. However, if the economy is in a recession phase, then corporate profits decline and almost all the stocks behave poorly..
As a result, even if a well-diversified portfolio has been established, the market cycle would still be influenced because almost every asset contained in the portfolio would shift in the same direction at the same time as the economy improved or deteriorated.
Since the investors can eliminate diversifiable risk through diversification and holding a portfolio of different stocks, eventually their only concern is the non-diversifiable risk of the securities they hold in their portfolio. That’s why the return that investors expect to receive should be based on their assessment of systematic risk, rather than total risk (systematic + unsystematic risk) in the specific security.