Systematic & Unsystematic Risk And CAPM by Daniel Subach
This article is a continuation of Subachís previous article
concerning diversification and risk reduction. This time, he
will explore systematic and unsystematic risk with respect
to total risk of investment. The capital asset pricing model
(CAPM) presents how the market prices securities and
helps determine expected returns. You must be compensated
for the risk of your investment, and the CAPM provides a
measure of the risk premium and a tool for estimating your
expected return curve.
In my previous article, I indicated that combining
securities into portfolios reduces risk. When securities
are combined, a portion of a stockís variability
in turn is canceled by complementary variations in the returns
of other securities. The total risk is the sum of unsystematic
risk and systematic risk. The capital asset pricing modelís
(CAPM) assumptions result in investors holding diversified portfolios to minimize risk.
If the CAPM correctly describes market
behavior, the measure of a securityís risk
is its market-related or systematic risk. The
CAPM provides insight into the marketís
pricing of securities and the determination
of expected returns. Therefore, it also has
a clear application in investment management.
The model relates to a firmís cost
of equity capital and the cost of equity for
the market as a whole. The tool will arm
you with a simple equation to assist you
in optimizing your investment decision
and the creation of your portfolio.