Here we’re going to talk about the difference between systemic risk and unsystematic risk. When we think of risk, in general, it’s basically the chance that a firm stock return is going to deviate and be different from what you were expecting. Let’s say that you buy stock on amazon.com and you have a certain expectation, you think “I’m going to get a 10% return on my investment in Amazon but that return it could be that you have a 40% return, it could be that you have a negative 40% return, it could be a return of 80% there’s a wide range of distributions. Amazon stock price is going to fluctuate up and down on a daily basis. Now some prices will fluctuate more than others and so that will be captured by the stock’s volatility. Which is the standard deviation of the stock returns.
Systematic Risk and Unsystematic Risk
So volatility is a measure of total risk, if we’re just thinking about a single stock it’s a measure of total risk but this total risk can itself be decomposed into two parts. There’s a part that has to do specifically with Amazon let’s say for example that the CEO was going to retire if the CEO of Amazon is going to retire that’s seen as firm-specific that doesn’t affect Kroger grocery store or Microsoft or something if the CEO of Amazon retires. That largely just affects Amazon. These are firm-specific another way of calling that is an unsystematic risk.
Now in addition to that this the second type of risk is systemic risk. It was something like there’s a global economic slowdown, so the global economy slows down, and let’s say there’s a reduction and consumer demand and demand for things that Amazon sells like Kindle devices and so forth. Now because it’s a global economic slowdown that’s going to affect Amazon but it’s not specific to Amazon. It’s not firm-specific we’d say it’s market-wide we’ll call it market risk. This is just a risk to the overall market, it doesn’t have anything to do just the Amazon. That causes some problems to the stock price so there are these two types of risk.
Now you might be wondering “Well why does this matter, why do we even care about this?” The thing is that when we combine multiple stocks in a portfolio, so let’s say you’re an investor and you have a portfolio, you could buy Amazon but you could also buy Microsoft you could buy Netflix you could buy a steel company you could buy Alcoa they make aluminum. Now in this portfolio the more stocks you add to this portfolio the idea is that each of these even though Amazon will have things that happen specifically to Amazon, and Alcoa will have things that happen that are specific to Alcoa that as is portfolio gets larger those firm-specific risks are going to average out. These risks are going to average out so although Amazon might have something really bad happen specifically to Amazon one day, maybe Alcoa has things that are really good specific to Alcoa the next day. So the averaging out of these firm-specific risks we call that diversification.
Because of this diversification, diversify away firm-specific risks by holding a portfolio of firms instead of just one firm. We can also call unsystematic risk diversifiable risk. You might hear it called diversifiable risk, firm-specific risk, or systemic risk they all refer to the same concept. Also as volatility is the measure of total risks as you increase your portfolio the volatility is going to decrease. As you add firms to the portfolio, the volatility is going to decrease what we’ll talk more about that later articles but now since investors can basically diversify away from this firm-specific risk just by holding more firms in a portfolio then there’s not going to be any risk premium for holding firm-specific risk. So basically we’re going to get into this in future articles but when we talk about measuring the cost of equity for Amazon that isn’t going to be a function of any firm-specific risk. Because we can get a free lunch by holding a portfolio firm one of which is Amazon but then there are other firms too, maybe we got Walmart we’ve got Kroger grocery store. So we’ve got a number of firms in our portfolio. We ultimately can eliminate the firm-specific risk because they average out due to diversification and therefore the cost of equity is actually going to be a function of the market risk or the systemic risk. Because we cannot diversify the systemic risk.
Systemic risk is not diversifiable and that’s because the global economic slowdown hurts everybody. Because we can’t diversify away the systematic risk so when we think about what is the cost of equity, what is the risk premium associated with a particular firm stock, what we really need to be thinking about is the level of market risk or systemic risk that’s associated with Amazon or the firm in question because that’s really what’s going to drive the cost of equity for that firm. We’re going to talk about how we would measure the amount of systemic risk with a firm like Amazon and that’s going to be called beta. You might have heard of and we’ll be talking about the beta and the capital asset pricing model for us to me and cost equity for a firm in later articles.