variation undiversified Diversification and Systematic Risk The next slide

Variation undiversified diversification and

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variation - undiversified
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Diversification and Systematic Risk The next slide illustrates what happens to risk as you begin to add more and more stocks Standard deviation (σ) measures the total risk As one adds more and more uncorrelated assets to the portfolio – eventually, owning every stock in the market The total risk (σ) drops – but, doesn’t get to zero We call this remaining risk the “systematic” risk, or the risk that affects all stocks in the market to some extent FIN 300 - Risk and Return Pt. 2 27
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Total Risk in a Portfolio of Many Stocks FIN 300 - Risk and Return Pt. 2 28
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Systematic vs. Unsystematic Risk We categorize stock market risks as being systematic and unsystematic Unsystematic, or idiosyncratic, risk affects isolated individual stocks and industries It is firm-specific or industry-specific We are able to diversify (or, smooth) away unsystematic risk by adding uncorrelated assets Systematic (or, market) risk affects all stocksto some extent Systematic risk can’t be diversified away Even, if you owned every stock in the market, you would be exposed to systematic, or market, risk FIN 300 - Risk and Return Pt. 2 29
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Examples of Systematic & Unsystematic Risk Unsystematic (firm- or industry-specific) risksexamples (microeconomic) Unexpected loss of a CEO Unexpected earnings change Strike or shortage in a particular industry Regulatory change isolated to just one part of the economy Systematic riskexamples (macroeconomic) Interest rates Federal Reserve policy GDP, unemployment reports Financial crises – you can’t diversify away a global crisis! FIN 300 - Risk and Return Pt. 2 30
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Systematic vs. Unsystematic Risk Nondiversifiable risk; Systematic Risk; Market RiskDiversifiable Risk; Nonsystematic Risk; Firm Specific Risk; Unique RisknσPortfolio riskWe’ll see later that we measure the systematic risk with the beta (β) The total (systematic + unsystematic) risk is measured by sigma (σ)
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