The worldwide economic is conducted in a very dynamic environment. As a consequence, majority of companies’ achievements largely depend on fate. However, during the last years theory of probability and study of the economical environment have moved aside the role of fate in economic. Now companies are able to foresee some risks exposed to their activity, thus, to avoid or minimize their impact.
Many types of risks may affect the company. Some may stand beyond the direct control of the management, for example, political changes or movement of exchange rates. Other risks may be controlled by the management of the company as they are of internal nature, for example, risks arose as a result of violation of laws or ignorance of financial reporting procedure (Hyderabad).The concept of risk is very important in financial analysis, especially considering its affect on rates of return and security prices. Probability of low or negative future returns is the background of investment risk. There are two ways to illustrate the riskiness of an asset: a stand-alone basis, according to which cash flow of an asset is analyzed by itself, and portfolio approach of capital investment, were analyze of consolidated cash flows is provided.
Understanding of total security risk and its relation to non-diversifiable and diversifiable risks comes from the portfolio approach, and namely from the Capital Asset Pricing Model (hereinafter – CAPM). According to the CAPM all portfolios are exposed to the risks that are grouped into two forms: systematic risks and individual stock risks. (Money-Zine.Com).As written in Money-Zine.Com, individual stock risk also known as specific risk or a diversifiable risk is security specific risk. It represents that part of total risk of the company that can be eliminated or reduced. This risk depends on the different factors that may vary from company to company and can be based on management decisions, strikes, and availability of raw materials, financial and operating forces of specific company.
For example, diversifiable risk may arise after lowering of stock price of the company as a result of its poor business decision. In this case stock market may experience growth but stock price of above mentioned company would fall. So, in order to decrease this risk, investors usually hold a diversifiable portfolio. The background of diversification is a loose relationship between the returns of the assets in the portfolio. Generally, procedure of diversification can be represented with a well-known proverb ‘Don’t put all your eggs in one basket’ (Transtutors.Com).
As diversifiable risk can be removed through diversification, the non-diversifiable or systematic risk is the only important risk. That is why the company should be concerned, with non-diversifiable (systematic) risk. The article in Money-Zine.Com states that systematic risk is also known as non-diversifiable risk. It relates to risks of a macro-level and affects the overall market. Non-diversifiable risk is measured in relation to the risk of a diversified market portfolio.
According to Money-Zine.Com, this risk is measured in terms of Beta coefficient where Beta assesses the inconstancy of a security’s return in relation to the returns broader market portfolio. Also Beta is known as an index of the degree of co-movement of returns with market return. A Beta coefficient of one would mean that the risk of certain security equals to the market, a zero Beta coefficient shows that there are no risks in portfolio of the company related to the market, a negative Beta coefficient reflects an opposite relationship. Example of non-diversifiable risk could be a recession that may depress the entire stock market, war, inflation or political events. This risk can not be reduced by diversifying the portfolio. To mitigate non-diversifiable risks companies apply hedging, which is holding together in a single portfolio certain number of negatively correlated assets. Let’s take the situation when business world experience economic recession. In this case stocks prices are decreased while the prices of gold are increased. Thereby, investors hold the gold as a hedge.
According to McClure, modern portfolio theory advises removal of all possible risks through diversification. However, there is still the problem as diversification does not eliminate systematic or non-diversifiable risks of the company. Even a portfolio of all the shares in the stock market won’t be able to mitigate this risk. That is why, when companies want to compute rightful return they are mostly worried about systematic risk.
To sum up, all above mentioned we need to say that diversification largely helps companies to manage risk. But no matter how diversified portfolio of the company is, the total risk can never be removed in total. Company can reduce internal risks related to individual stocks, but external risks will remain and affect the business. That is why, I agree with the proposal stated by McClure regarding necessity to diversify also among different classes of asset. The best decision is to find a medium between expected return and risk; in this case the probability of financial goal achievement of certain company will be significantly higher.
Hyderabad (2005). Why is risk management important? Rediff India Abroad. Retrieved from: http://www.rediff.com/money/2005/dec/27guest.htm
Lowering Portfolio Risk through Diversification. Money-Zine.Com
Retrieved from: http://www.money-zine.com/Investing/Investing/Lowering-Portfolio-Risk-through-Diversification/
McClure, Ben (2010). The Capital Asset Pricing Model: An Overview. Investopedia.
The Capital Asset Pricing Model (CAPM Model) Assignment Help. Transtutors.Com
Retrieved from: http://www.transtutors.com/finance-homework-help/risk-and-return/The-Capital-Asset-Pricing-Model.aspx