Diversification cannot eliminate all risk. Sharpe-Lintner-Black tried to determine what part of a security’s risk can be eliminated by diversification and what part cannot. The result is known as the Capital asset pricing model (CAPM). The basic logic is that there is no premium for bearing risks that can be diversified away. Thus, to get a higher average long-run rate of return in a portfolio, you need to increase the risk level of the portfolio that cannot be diversified away.
I. Beta and Systematic risk
1. Two kinds of risks: systematic risk and unsystematic risk. Systematic risk cannot be eliminated by diversification. It is because all stocks move more or less in tandem that even diversified stock portfolios are risky. Unsystematic risk is the variability in stock prices that results from factors peculiar to an individual company. The risk associated with such variability is precisely the kind that diversification can reduce.
2. The whole point of portfolio theory is that, to the extend that stocks don’t move in tandem all the time, variations in the returns from any one security tend to be washed away or smoothed out by complementary variation in the returns from other securities.
3. The beta calculation is essentially a comparison between the movements of an individual stock (or portfolio) and the movements of the market as a whole. Professionals call high-beta stocks aggressive investments and label low-beta stocks as defensive.
4. Risk-averse investors wouldn’t buy securities with extra risk without the expectation of extra reward. But not all of the risk of individual securities is relevant in determining the premium for bearing risk. The unsystematic part of the total risk is easily eliminated by adequate diversification. The only part of the total risk that investors will get paid for bearing is the systematic risk, the risk that diversification cannot help.
1. Before the advent of CAPM, it was believed that the return on each security was related to the total risk inherent in that security.
2. The theory says that the total risk of each individual security is irrelevant. It is only the systematic component that counts as far as extra rewards go. The beta is the measure of the systematic risk.
3. As the systematic risk (beta) of an individual stock (or portfolio) increases, so does the return an investor can expect.
4. If the realized return is larger than that predicted by the overall portfolio beta, the manager is said to have produced a positive alpha.
III. Look at the record
1. Fama and French found that the relationship between beta and return is essentially flat.
2. The author believes that “the unearthing of serious cracks in the CAPM will not lead to an abandonment of mathematical tools in financial analysis and a return to traditional security analysis. There are many reasons to avoid a rush to judgment of the death of beta:
a. The beta measure of relative volatility does capture at least some aspects of what we normally think of as risk.
b. It is very difficult to measure beta with any degree of precision. The S&P 500 Index is not “the market”. The total market contains many additional stocks in the US and thousands more in foreign countries. Moreover, the total market includes bonds, real estate, precious metals, and also human capital.
c. Investors should be aware that even if the long-run relationship between beta and return is flat, beta can still be a useful investment management tool.
IV. Arbitrage Pricing Theory
1. It is fair to conclude that risk is unlikely to be captured adequately by a single beta statistic. It appears that several other systematic risk measures affect the valuation of securities.
2. In addition, there is some evidence that security returns are related to size, and also to P/E multiples and price-book value ratios.
3. If one wanted for simplicity to select the one risk measure most closely related to expected returns, the best single risk proxy turned out to be the extent of disagreement among security analysts’ forecast for each individual company. Companies for which there is a broad consensus with respect to the growth of future earnings in dividends seem to be considered less risky than companies for which there is little agreement among security analysts.
To sum up, the stock market appears to be an efficient mechanism that adjusts quite quickly to new info. Neither technical analysis, nor fundamental analysis seems to yield consistent benefits. It appears that the only way to obtain higher long-run investment returns is to accept greater risks.
Unfortunately, a perfect risk measure does not exist. The actual relationship between beta and rate of return has not corresponded to the relationship predicted by the theory during long periods of the twentieth century. Moreover, betas for individual stocks are not stable over time, and they are very sensitive to the market proxy against which they are measured.
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