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In spite of unique or diversifiable factors that differ across firms, asset or stock values and returns
still tend to move up or down with general economic and financial market conditions. In good years,
most investments earn good returns—not all investments, but certainly most. In poor years, most
investments earn poor returns. There are common factors that drive economic conditions in favorable
or unfavorable directions, and, not surprisingly, these common factors also impact the value and
returns of most assets and stocks. Examples of common factors that impact economic conditions and
asset returns include commodity prices, interest rates, foreign exchange rates, inflation, and consumer
confidence, to name just a few. These common factors, called market, nondiversifiable, or systematic
factors, cannot be eliminated by investing in portfolios, because the individual assets in the portfolio
are all, or nearly all, affected by these factors. No matter how the portfolio is constructed or how many
assets are in the portfolio, changes in these factors will affect the returns of most of the component
assets in a similar manner, and will therefore affect the returns of the entire portfolio as well. Market
or systematic risks are not diversified by holding a portfolio of assets, as this particular type of risk is
not reduced.
We have seen that assets and stocks carry two different types of risk. Nonsystematic risks are
unique to individual stocks, and as long as these stocks are held in a portfolio and have less than
perfectly positive correlation, this type of risk is reduced. As the number of stocks in a portfolio
increases, this risk gets smaller and smaller, and once the portfolio contains approximately 30 assets or
stocks, the unique or nonsystematic risk is eliminated. Unique or nonsystematic risk, therefore, is
irrelevant; it is not priced, and investors are not rewarded for holding it, because it can be easily
eliminated.
Systematic or market risk, in contrast, which is created by factors common to all assets or stocks,
cannot be diversified. This risk cannot be eliminated, no matter how many stocks are in a portfolio.
Systematic or market risk, therefore, is relevant, it is priced, and investors expect to be rewarded for
holding it. This logic is the basis of the capital asset pricing model (CAPM), which states that the
appropriate measure of risk for any asset is that particular asset‟s contribution to the risk of a portfolio.
This measure of risk for any asset or stock in a portfolio is determined by the mathematics of the
standard deviation of the portfolio. For example, if a portfolio contains two common stocks, stock A
and stock B, the standard deviation of the portfolio is defined by a two-by-two variance/covariance
matrix, which contains four statistical components: the variance of stock A, the variance of stock B,
the covariance between stock A and stock B, and the covariance between stock B and stock A (which
is identical to the covariance between stock A and stock B). In this portfolio of two stocks, there are
two variance terms and two covariance terms, so in a small portfolio the variance of the individual
stocks contributes significantly to the standard deviation of the portfolio.
If you have not encountered covariance in your studies, the covariance between any two stocks
measures the extent to which the stocks move together and the volatility of these movements. Stocks
with high covariance tend to have large movements frequently in the same direction, so placing stocks
with high covariance together in a portfolio does not reduce the risk of the portfolio very much. Stocks
with small covariance, in contrast, tend to have smaller movements less frequently in the same
direction, so placing stocks with low covariance together in a portfolio reduces the risk of the portfolio
much more.
If a portfolio contains five stocks it has five variance terms, one for each stock in the portfolio. With
five stocks in the portfolio, the variance/covariance matrix is five by five, 25 terms in all. Since there
are five variance terms, there are also 20 covariance terms, so the variance of the individual stocks