In this article, we’re gonna talk about why you need to be careful when using volatility as a measure of risk for just a single firm stock. Risk is the chance that a firm stock return is gonna deviate or be different from the return that you’re expecting. When you buy the stock, let’s say that we’ve got two firms firm A and firm B and they both have the same expected return but firm A, their historical returns have looked like this, and firm B their historical returns look like that.
Obviously, firm B is going to have more volatility. So it would be tempting for you to say “Hey, look I can estimate the cost of equity capital or the risk premium for firm B and firm a by just looking at volatility” but you gotta remember something volatility is a measure of a firm’s total risk. We could break that total risk out into two parts. We’ve got the systemic or market risk and then we’ve got unsystematic which is the firm-specific risk.
So let’s say that firm B here let’s say, that was eBay. So in eBay, there are certain events that happen that are specific to eBay, let’s say the CEO gets fired and the stock market reacts but there is also a market risk which is just general economic conditions that affect not just eBay but the entire US economy. So when we look at volatility the volatility is including both market risk and firm-specific risk and you might be thinking that’s what I want to know the total risk. But here’s the thing when you’re an investor you can build a portfolio of firms. Where you not only have eBay you also maybe have Target you have Microsoft you have a number of firms and as you increase this portfolio and include more and more firms you’re going to be reducing your volatility. Your volatility of the portfolio is going to go down and the reason is that you’re engaging in diversification.
So basically diversification is the averaging out of all those firm’s specific risks and if you can get rid of the firm-specific risks by holding a large portfolio of firms then it doesn’t really matter if eBay had some firm-specific risk because that can be diversified away. That’s not to say that you don’t care about any risk at all, you obviously need some way to evaluate risks to come up with the cost to equity capital and the market premium for eBay’s stock but the way you do that is what you really want to isolate is the market risk.
So you don’t really care about the firm-specific risk you’re gonna diversify that away and so forth. So really you don’t want to be thinking how do we estimate the cost of equity capital for eBay or the market premium? We don’t want to be thinking about volatility because that’s a measure of just total risk, what we really want is a measure of market risk which is gonna come from eBay’s beta. We’ll talk about that in a future article.
Now, this is not to say that we don’t care about volatility. When it comes to something like the portfolio itself we could actually compare multiple portfolios and we could take into consideration the volatility of the portfolio. I’m just saying here volatility for a single stock is not a good way to estimate the cost of capital, we want the beta of the market risk. Now, with the portfolio volatility becomes important we’re actually going to talk about something called the Sharpe ratio where you can actually compare different portfolios and basically see which portfolio gives you more bang for your buck in terms of the excess return that you get per unit of volatility and we’ll talk about that in the future articles.