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Why an investor should not expect to receive additional return for bearing unsystematic risk?

Why an investor should not expect to receive additional return for bearing unsystematic risk?

Unique, diversifiable, or unsystematic risk (or nonsystematic risk) is risk that can be diversified away. This risk is offset by the unique variability of the other assets in a portfolio. An investor should not expect to receive additional return for assuming unsystematic risk.

Why investors are not getting rewarded for bearing idiosyncratic risk?

Once the company itself considers only market risk for its own projects, it is logical for small, undiversified investors to expect compensation for this portion of risk only. This is because these investors are not in a position to alter the decision-making powers of the managers of the company.

Why might it be argued that investors should not be compensated for holding unsystematic risk?

Because the risk of single-stock ownership can be diversified away, the market doesn’t compensate investors for assuming this type of (unsystematic) risk. And because the risk can be diversified away without lowering expected returns, why so many investors hold concentrated portfolios remains a puzzle.

Should investors be rewarded for bearing unsystematic risk?

Therefore, by diversifying, one can reduce their risk. There is no reward for taking on unneeded unsystematic risk. However, the expected returns on their investments can reward investors for enduring systematic risks. Investors are induced to take risks for potentially higher returns.

Is an example of unsystematic risk?

Examples of unsystematic risk include a new competitor in the marketplace with the potential to take significant market share from the company invested in, a regulatory change (which could drive down company sales), a shift in management, or a product recall.

What risk can an investor expect to be compensated for?

Investors expect to be compensated for the risk they undertake when making an investment. This comes in the form of a risk premium. The equity risk premium is the premium investors expect to make for taking on the relatively higher risk of buying stocks.

Is idiosyncratic risk priced?

In Merton (1987), idiosyncratic risk is priced in equilibrium as a consequence of incomplete diversification. This simple recognition results in a state-dependent idiosyncratic risk premium that is higher when average idiosyncratic volatility is low, and vice versa.

How do you manage idiosyncratic risk?

The most effective way to mitigate or attempt to eliminate idiosyncratic risk is with the diversification of investments. Idiosyncratic risk, by its very nature, is unpredictable. Studies show that most of the variation in risk that individual stocks face over time is created by idiosyncratic risk.

Why are some risks Diversifiable?

Diversifiable risk is the possibility that there will be a change in the price of a security because of the specific characteristics of that security. Diversification of an investor’s portfolio can be used to offset and therefore eliminate this type of risk.

Does diversification reduce unsystematic risk?

Diversification reduces risk by investing in vehicles that span different financial instruments, industries, and other categories. Unsystematic risk can be mitigated through diversification while systemic or market risk is generally unavoidable.

How do you deal with unsystematic risk?

The best way to reduce unsystematic risk is to diversify broadly. For example, an investor could invest in securities originating from a number of different industries, as well as by investing in government securities. Examples of unsystematic risk are: A change in regulations that impacts one industry.

Can unsystematic risk be positive?

However, unsystematic risk can also be positive for a company, with certain occurrences such as a competitor going bankrupt, and products or marketing communication going viral. An investor can protect themselves from unsystematic risk by diversifying their portfolio well.

What do you mean by unsystematic risk in investing?

Unsystematic risk is diversifiable, meaning that (in investing) if you buy shares of different companies across various industries you can reduce this risk. Unsystematic risks are often tied to a specific company or industry and can be avoided.

What kind of risk can be eliminated through diversification?

Unsystematic risk, or specific risk, is that which is associated with a particular investment such a company’s stock. Unsystematic risk can be mitigated through diversification, and so is also known as diversifiable risk. Once diversified, investors are still subject to market-wide systematic risk.

How is the expected return of a portfolio measured?

Answer: In every scenario, the return on the portfolio is 10% so the expected return must also be 10% and the standard deviation is 0%. A) provides a risk-return trade-off in which risk is measured in terms of the market returns. B) provides a risk-return trade-off in which risk is measured in terms of beta.

How to manage risk and return in a portfolio?

20) Adequate portfolio diversification can be achieved by investing in several companies in the same industry. 21) A portfolio will always have less risk than the riskiest asset in it if the correlation of assets is less than perfectly positive. 22) The standard deviation of returns on Warchester stock is 20% and on Shoesbury stock it is 16%.