Investment Theory and Systematic Risk | Risk Reward Ratio | Investment Analysis| Week 3 DQ1 | Discussion Question | | Westcliff University
Question : Why investment theory relates reward for the risk only with systematic portion of total risk? Explain.
Answer:
Investment theory relates rewards for the systematic risk only because we know that the unsystematic risks are the types of risks that are diversifiable in nature which can be managed and reduced by the process of diversification. They are more related to firm-specific factors and are not related to the market. Unlike unsystematic risk, systematic risks are more related to the market factors and are undiversifiable in nature which is mainly caused by the systematic forces (supply of money, business cycle, level of interest rate, inflation, economic growth, etc.) in the macro-environment.
The reward is associated with only the systematic portion of total risk because even forming a diversified portfolio these types of risks cannot be diversified. Almost all the other types of investment risks are underlined by the systematic risks. Systematic risk of security can be measured by the beta compared to the market as a whole (Moore, 2018). Generally, in comparison to the whole/larger market sense of the stock market can be understood by beta which is used in CAPM (Capital Asset Pricing Model).
For example, If there is inflation in the economy then the investors can invest in the stocks of the economic sectors which can resist -inflation. If the rate of interest is getting high then different types of stocks related to the utility can be sold and you can invest in the bonds that are newly issued. If interest rates are high, you can sell your utility stocks and move into newly issued bonds. But there is a case of falling the entire market then it will be completely impossible to eliminate the systematic risk.
One of the biggest examples of systematic risk is “The Great Recession” which was happened in the past. All those investors who have had stocks saw the variation of the value of their stocks regardless of the quality of the stock in the market because of the macroeconomic event that hit the nation.
These types of systematic risks affect the broad category of securities but the unsystematic risks only affect a certain specific group of securities which can even be mitigated by the process of diversification. Since it is impossible to eliminate systematic risk, investment risk is relevant and investors should be rewarded for taking this risk. Therefore investors are rewarded for taking these types of risks.
References
Moore, D. (2018, June 27). Managerial Finance: Explain why systematic risk is the “relevant’ risk of an investment and why investors should be rewarded only for this risk. Retrieved from One Class: https://oneclass.com/homework-help/finance/56387-managerial-finance-explain-why.en.html
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