Last Updated 07 May 2020

# Systematic and Unsystematic Risk

Investors, by their very nature, wish to achieve good returns on their investments, and that too, mostly without taking disproportionate risks. This, unfortunately, is an inherently contradictory desire as high returns are always associated with greater risk.

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Most of these stories, which deal with huge trading profits made by individuals, are of questionable authenticity and anecdotal in nature; nevertheless, they serve to engage the attention of investors and keep their hopes alive through boom and bust times, through depressions and terrorist attacks. One of the main purposes of most investors in stocks, shares or other assets is to maximise the anticipated returns in a specific risk category; or, to put it differently, to minimise risk for a specified level of anticipated re turns.

It is important to specify at this stage that whilst risks is also used to represent chances of general hurt, harm or loss, its connotation, in terms of investments, reflects unpredictability regarding the rates of return provided by stocks, bonds, or other assets. It should not be confused with uncertainty in any routine business process and should be taken to denote the variance of historical rates of return from the average rate of return.

The total risk of the investment portfolios of investors can be modified through diversification of investment choices, to elaborate by planning and investing in different sorts of available investment opportunities, namely, stocks, bonds, securities, bank deposits, gold, art, property or real estate (Bodie & Others, 2005). Again, even in the case of specific investment opportunities, risk can be spread, reduced or even increased by investing in the shares of different companies or different business sectors.

Whilst risks can be modified in this manner, it needs to be noted that they cannot be eliminated completely because changes in market conditions can lead to price variations in all kinds of assets (Bodie & Others, 2005). The current financial crisis provides an example where investments in various investment avenues, stocks, real estate and even bank deposits carry the risk of losses and underlines the fact that this unpredictability in risk cannot be eradicated totally by diversification alone.

Risks can as such be segregated into two segments, the first reflecting that component of the price movement of an asset that occurs because of changes in the market as a whole and the second representing the other component of the price movement that is due to factors or variables that are unique to the company or industry itself. The first category of risks is known as systematic risk and the second as unsystematic risk (Bodie & Others, 2005). The second category of risks, namely unsystematic risks can be controlled through judicious selection of companies or other investment opportunities (Bodie & Others, 2005).

It is the first category, systematic risks, which are greatly unpredictable and are thus referred to as the really relevant risks. 1. b & c. Capital Asset Pricing Models and Beta The Capital Asset Pricing Model, CAPM, was conceptualised by William Sharpe as far back as the early sixties and has since evolved into one of the chief models for managers to control risks while taking investment decisions. It is an equilibrium model that describes the pricing of assets as well as derivatives (Bodie, 1998). The CAPM is the single most used model for valuing securities and uses the Discounted Cash Flow system with risk adjusted discount rates.

It postulates that entry into markets opens investors to two types of risks, systematic risks that arise from just being present in the market, and unsystematic risks, which arise from investing in particular companies. As unsystematic risks can be controlled through a process of diversification, the main risk in portfolio decisions comes from systematic risks. The CAPM elaborates the association between risk and expected return and is commonly used in the pricing of risky securities (CAPM, 2008). According to the postulates of the CAPM, lay investors need to be compensated in two different ways for their investments.

The first relates to the time value of money; this is known as the risk free rate and denotes the amount that investors will certainly get if they hold their investments for a specific period of time. The second relates to compensation for the risk borne by an investor and increases with the perceived risk of the investment (CAPM, 2008). This is calculated by taking a risk measure known as a Beta, a figure that compares the returns of the asset to the market over a period of time and to the market premium (CAPM, 2008). Beta measures the volatility of the security, relative to the asset class.

With the CAPM formula postulating that investors require higher levels of expected returns to compensate them for higher expected risk, the formula can be considered as one that predicts a security’s behaviour as a function of beta; the assumption being that knowledge of beta should be enough to calculate the rate of return that investors should expect from particular securities (CAPM, 2008). The following graph, taken from the moneychimp (2008) site represents this pictorially. The expected return of a security or an investment portfolio should equal the rate on a risk-free security plus a risk premium (Bodie, 1998).

Investments should, as per the CAPM, be accordingly be undertaken if and only if the rate of return expected from the investment equals or is more than the total of these two rates of return, i. e. that for time and that for risk (Bodie, 1998). Betas provide finance managers and analysts with a number of advantages. They are used by stock analysts constantly to get an idea of the risk profiles of different stocks (CAPM, 2008). With the market, by definition, possessing a Beta of one, the ranking of individual stocks depends upon the quantum of their deviation from the market (CAPM, 2008).

Calculated by using regression analysis, a beta that exceeds one indicates that the price of the concerned security is expected to be greater than the market whereas a beta less than one implies that it will tend to be less volatile than the market (CAPM, 2008). The value of the Beta enables analysts and managers to fix the discount rate for estimation of cash flows; the higher the beta, the greater will be the cost of capital discount rate; a factor that in turn plays an important role in the assessment of share valuations (Cates, 1998).

By being a clear and quantifiable method to gauge risk, it works as a straightforward measure for computation of cost of equity and share valuation, and makes investment decisions easier (Cates, 1998). The concept however has a number of limitations. It is unable to incorporate new information, especially the changes that can occur to a company after it enters new areas of business. The use of Standard Deviation is moreover not an adequate method of computation when returns are not evenly distributed around the mean (CAPM, 2008).

Many new technology stocks again do not have enough price history for the computation of Betas. Cynics, Warren Buffet being one of them, argue that the measure is dependent upon past data and is a poor indicator of the future. Betas are furthermore not the only indicators of risk and the CAPM, which uses only Beta values for factoring risk returns can be deemed incomplete in this respect (Bodie, 1998). Investors also face other risks, for example the chances of portfolios being devalued by future inflation.

Investors who wish to change the composition of their portfolios may be unable to sell their holdings at the market price, thus facing a liquidity risk. 2. a. Time Value of Money and Importance of Discounting Future Cash Flows The time value of money is a vital concept; it is so important that it virtually lays the foundation for all other concepts in finance. Flowing from the concept of interest it plays an important role in all transactions involving the exchange or transfer of money.

Time value, as a concept, is easier to explain with the help of illustrations rather than with plain theory. Very obviously people who are owed money by others are better of being paid at the earliest possible date, such early payment allowing them to use the money in various ways. Apart from allowing the recipient to spend the received money on fulfillment of various requirements, early payment also enables the receiver to invest the money in an interest bearing account that will steadily grow with time.

When considering the monetary benefit of interest, whilst it is acceptable to consider simple interest for short periods, longer periods entail the application of compound interest. In addition to earning interest, the time value of money is also related to the concept of opportunity cost as the cost of any decision includes the cost of any opportunity that had to be forgone because of it. Late receipt of money may preclude viable and profitable opportunities that the money could have been used for if received on time.

Early receipt, within a certain date, may have made it possible for the recipient to invest in a cheap residential property or an initial share issue, and make financial profits, an opportunity that would not have been available if the money were to be received later. Discounting of cash flows is a method that enables expected future receipts and payments of money to be converted to its present day value using the concepts of time value of money that have been elaborated in the previous paragraphs. The same principles can also be used to convert present day cash flows into its future values at specified periods of time.

Discounted cash flow calculations have been used, in some form or other, ever since people started lending money; in the modern day it became popular after the Wall Street crash of 1929 and now forms one of the most important and widely used tools of financial management. It is routinely applied in numerous situations involving personal and organisational finance decisions. Whilst the intrinsic value of most assets are dependent to a large extent upon the future benefits they are expected to bring, the value of investments are specifically related to their future cash flows, which in turn could come about from various avenues, viz.

sale proceeds, rents, dividends, interest, bonuses, and the like. “Interest charges make the value of a unit of money to be worth more now, than at some time in the future; i. e. , inflation occurs. This has a profound effect on investments. Since the value of an investment made now declines with time, the return that it generates must not only be finite but must increase with time at a rate that compensates for the loss of value of the initial investment. That is, in the language of economics, the net discounted-cash flow must be positive” (Gilman, 2006)

These cash flows need to be adjusted for two parameters, namely the time value of money and the risk that the actual money receipt in future may be different from that forecasted today. The failure to do so could well lead to a completely misleading picture of the true worth of expected cash flows and the financial viability of projects, investments and other money making enterprises, especially if inflows and outflows are unevenly scattered both in amount and in points of payment and receipt.

It is for this reason that the technique is widely used both in personal and business dealings that are related to finance. “Simple static balances of expenditures against income are not good enough because the value of money changes with time as a result of interest charges. The latter are necessary for a stable system of trade which in turn is needed for economic stability. Some societies have tried to operate without interest charges (for religious reasons), but have only succeeded in impoverishing themselves. ” (Gilman, 2006) 2. b.

Choosing of Discount rate The discount rate can be best described as a desired return, or to elaborate further, the return an investor would expect to receive any other equally risky proposition or line of action. It typically consists of two factors (a) a rate or measure to factor in the time value of money, money in hand being far more preferable than that to be received later and (b) a rate to factor in the cost of risk, there necessarily being uncertainty over future receipts of any kind and by whosoever guaranteed (Levy, 1996).

There is no single rate of return that is appropriate for every project. In cases of firms, it is very common to use the tax adjusted weighted average cost of capital (WACC). Whilst the use of WACC is widespread its usage is open to debate, with many analysts feeling that it does not truly represent the risks that could come into play for riskier or longer term projects, the chances of money coming in being inversely proportional to the number of years after which it is expected (Levy, 1996).

Some organisations apply a variable discount rate to overcome this problem, with the rate being increased for cash flows that are expected a specified cut off period. Some people on the other hand choose the discount rate on the basis of the rate applicable for a different project that guarantees a specified return. The computation of present cash values on this basis enables a direct comparison of the viabilities of the two projects. Another commonly used rate, chosen for discounting expected cash flows, is the firm’s reinvestment rate, which is basically the average rate of return of the firm’s various investments.

This is often used during periods of capital constraint and places emphasis on opportunity cost rather than on weighted cost of capital, which may well be lesser than the reinvestment rate. 2. c. NPV and IRR Net Present Value (NPV) and the Internal Rate of Return (IRR) are the two most frequently used measures for evaluating the viability of investments and projects. Both methods are dependent upon the availability or crystallisation of the income stream, which denotes the incomes that are associated with the project or investment, both positive and negative, over its total life.

The NPV of an income stream is computed by calculating the present value of all such incomes with the use of a chosen discount rate to get their net present values and adding them together to get a total picture of the income from the investment at today’s valuation; the word “net” according to some researchers being used to emphasise the fact that the discounted and thus present values of incomes are net, i. e. positive minus negative incomes (Levy, 1996).

The NPV of an investment enables analysts to gauge the profitability of a project in absolute terms, as well as in comparison with other projects, positive or higher NPVs implying the superiority of particular projects. NPV computations are by and large characterised by 3 traits; (a) higher incomes increase the NPV, (b) earlier profits increase the NPV, and (c) changes in discount rates affect the computation of NPV (Levy, 1996). The IRR of a project looks at the issue of investment analysis through a somewhat different angle.

It is the rate that after being used for discounting income streams leads to a NPV of zero, the viability of a project being assessed by its comparison with the WACC and being dependent upon the IRR being higher than the WACC (Levy, 1996). 2. d. Comparison of NPV and IRR Most analysts tend to use both IRR and NPV calculations whilst making investment decisions. With all things being the same there is usually little to differentiate in the results that are available with the use of IRR and NPV.

However complexities of business constantly add new dimensions to investment and business issues, a fact that makes the use of IRR less effective than NPV in many cases and exposes its limitations. IRR’s major limitation occurs from the fact that it uses just one discount rate for evaluating all investments. Whilst simple to use and applicable for projects that have common discount rates, predictable cash flows, equal risks, and short time horizons, the fact that discount rates often change substantially over time in real life situations makes the use of the technique inadequate for projects with longer lives.

Single IRR’s are also ineffective in projects that have a multiple of positive and negative income streams and where market conditions are expected to change in future (Levy, 1996). They are also difficult to use when the comparison rate, the WACC, or any other applicable rate is relatively unknown or difficult to estimate, thus making investment comparisons impracticable. In most such cases, the NPV provides a far better method of evaluating investments.

Whilst it needs more assumptions in terms of different discount rates and the quantification of risks associated with receiving payments, and is inherently more complex than IRR, the NPV method is far more suitable for evaluating investments that have multiple cash flows, need different discount rates, or where cash flows are uncertain. With these conditions being common for most projects, NPV easily scores over IRR as the more appropriate method of evaluation of investments. References Active Fund Management and Investment Strategies, 2006, Investment Management, Retrieved December 12, 2008 from www.

londonexternal. ac. uk/... /lse/lse_pdf/further_units/invest_man/23_invest_man_chap3. pdf Bodie, Z, Kane, A and Marcus, 2005, Investments, McGraw Hill, USA Burton, J, 1998, Revisiting the Capital Asset Pricing Model, Dow Jones Asset Manager, Retrieved November 12, 2006 from www. stanford. edu/~wfsharpe/art/djam/djam. htm Capital Asset Pricing Model , 2008, moneychimp, Retrieved December 12, 2008 from http://www. moneychimp. com/articles/risk/classes. htm Cates, D. C, 1998, Turning Shareholder Value into Stock Price ABA Banking Journal, 90(5), 59

Gilman, J. J, (2006), The Critical Importance of Discounted Cash Flow, Materials Technology 21-1: 1-63. 1066-7857 Guido, R. , & Walsh, K, 2001, Equity Market Valuation: Assessing the Adequacy of Value Measures to Predict Index Returns. Australian Journal of Management, 26(2), 163+ Investment funds from Barclays Global Investors, 2006, Retrieved December 12, 2008 from http://www. bgifunds

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