Stocks & Commodities V. 31:1 (14-18): Systematic & Unsystematic Risk And CAPM by Daniel Subach

Stocks & Commodities V. 31:1 (14-18): Systematic & Unsystematic Risk And CAPM by Daniel Subach
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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.

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