Understanding Risk: Systemic versus Idiosyncratic

Abstract

Using the fictional situation of two brothers facing the challenge of managing a commodity business in central Africa, this note explores different metrics for risk and related considerations for investors. The note considers measures of volatility, including the difference between systematic risk and idiosyncratic risk, and how diversification reduces idiosyncratic risk. The note uses these concepts to motivate the foundations of portfolio risk assessment by rational investors and the theory of the capital asset pricing model.

Excerpt

UVA-F-1973

Rev. May 12, 2021

Understanding Risk: Systematic versus Idiosyncratic

Risk is a central concept in finance. Finance theory asserts that the more risk investors bear, the more expected return investors will require. This risk-return relation is fundamental to everything in finance. As such, it is critical to understand what risk is and how to think about it. This note explores different metrics for risk and related considerations for investors. The note considers measures of volatility, including the difference between systematic risk and idiosyncratic risk, and how diversification reduces idiosyncratic risk. It uses these concepts to motivate the foundations of portfolio risk assessment by rational investors and the theory of the associated risk premium.

As context for this introduction, we consider the situation of Daniel and Julian Kasongo, two brothers facing the challenge of managing a commodity business in central Africa.

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Keywords: systematic risk, idiosyncratic risk, portfolio theory, volatility, diversification, capital asset pricing model, CAPM