Risk is quite possibly one of the most commonly used words in Finance. Whether it is an article in the FT or an interview with an asset manager on CNBC, risk is a factor that appears in every Finance playbook. However, the term itself can be used quite loosely, leading to a great deal of conflation and confusion. Therefore, it is important to determine the type of risk being discussed – especially when discussing equities – and how investors see risk as an effective measure for diversification and portfolio management.

What is risk?

When discussing equities, it is important to split risk into systematic risk and unsystematic risk.

Systematic risk is best defined as inherent risk that is applicable to the entire market. Undiversifiable, systematic risk affects the whole market and is a function of more macroeconomic variables such as interest rates, inflation and GDP growth rates. 

Unsystematic risk is risk that is inherent in a specific company or sector. Also known as specific risk, it is diversifiable and a function of more firm-specific factors such as changes in management and company financial statements. 

The addition of the two is equivalent to total risk. However – as mentioned above – it is possible to completely eliminate unsystematic risk such that total risk becomes equivalent to only systematic risk. Due to the fact that prices of different shares move in different directions, a well-diversified portfolio would result in these price movements cancelling each other out, leaving only systematic risk remaining. The larger the diversification, the greater the reduction in firm-specific risk. This relationship is shown below, where standard deviation of the portfolio is shown as a gauge for the total risk. Notice the convexity of the risk line – the rate of reduction of portfolio risk steadily decreases as the number of shares added to the portfolio increases.

Diversification and the role of Beta

If an investor is well-diversified and holds a portfolio equivalent to systematic risk, what risk is added to the portfolio if said investor adds a security to the portfolio? Now, only market risk matters, so the security’s relationship/co-movement with the market should be the additional risk that the investor adds to their portfolio. Introducing: Beta.

Beta is the sensitivity of a security to movements in the overall market. Statistically, it is the correlation between the movement of a security’s price and the movement of the overall market and can be inferred from regression analysis. A Beta larger than an absolute value of 1 signifies that the underlying security is more volatile than the market; a Beta of absolute 1 means that the security is as volatile as the market; and a Beta below absolute 1 means that the security is less volatile than the market. Notice the us of modulus – securities can move in the same or opposite direction to the market. 

Using Yahoo Finance [2], the following stocks showed the corresponding Betas as of 01/07/20:

From the figures it is clear that Microsoft stock is not as volatile as the market, whilst Tesla is slightly more volatile and Marathon Oil is significantly more volatile than the market. Therefore, when adding any of these securities to a portfolio, Marathon Oil would add the most risk, whilst Microsoft would add the least risk. 

Risk and return: Using CAPM

The CAPM (Capital Asset Pricing Model) is a model that details the required rate of return for holders of a firm’s shares by introducing a risk-free rate of return (typically a 10-year Treasury bond yield), a market risk premium (the difference in rate of return between a market portfolio and the risk-free rate) and its market risk (Beta). CAPM itself is useful for asset pricing via Dividend Discount Models and sometimes for finding the discount rate for a Discounted Cash Flow Model. Therefore, CAPM gives financial analysts the intrinsic value of a share of a company and is a valuable tool in the world of Finance.

The formula for the required rate of return via CAPM is [3]:

where:

 is the required rate of return for a company’s shares;

is the risk-free rate;

is the return on a market portfolio;

is the market risk of a particular firm’s shares;

Rearranging the formula to solve for the required rate of return yields:

which states that the rate of return for a company’s equity is directly proportional to its market risk (Beta), assuming that the risk-free rate and return on a market portfolio are constant.

So, the higher the risk (dictated by Beta), the higher the return demanded by shareholders. From a rational shareholder point of view, the higher burden of holding a security which is intrinsically riskier leads to the demand of a higher return on holding that security. From the example above, theoretically, the rate of return for Marathon should be higher than for Microsoft. Although this is not corroborated by average annual returns over the last five years [4]:

Risk-parity and multi-asset diversification

So far, this article has covered the concept of risk with regard to equities and portfolios composed of equities. However, it is possible to reduce portfolio risk further by constructing a portfolio composed of more than one asset class. The best example of this is the risk-parity strategy pioneered by Ray Dalio of Bridgwater Associates, which has consistently delivered better, steadier returns than most individual asset classes (below).

Risk-parity portfolios are composed of a wide range of asset classes – typically equities and bonds. However, there are a multitude of other assets available for investors: Inflation-protected bonds, currencies, call and put options, and corporate bonds, for example.  The overarching aim is for the portfolio to perform well in any investment climate. If there is bullish sentiment, the equities will tend to perform well; during downturns, safe-havens such as bonds will perform well. Effectively, a risk-parity portfolio has all bases covered.

However, risk-parity funds typically lever their fixed-income components so that all components of the portfolio have the same level of volatility (or risk). Although it is estimated that there is $175-400bn in risk-parity funds [6], the real figure is likely to be a lot more due to the aforementioned leverage in the fixed-income segments of funds. Although a risk-parity strategy is based around sizeable returns in any environment, the strategy is ill-prepared for a selloff across all capital markets. For example, the havoc wreaked by the outbreak of Coronavirus in the first quarter of this year led to selloffs in both equity and fixed-income markets (below) – yields on bonds are inversely related to price. Despite its success over the years, the recent selloff in global markets in Q1 2020 has led to increased doubt as to whether the strategy is as effective as it once was.

Tom Wookey