The Role of Risk in Investment Decision-Making

The Capital Asset Pricing Model In general, it is unlikely that the returns on financial assets will be negatively correlated. Economy-wide factors, such as the level of interest rates, general level of demand, exchange rates, etc. will affect all companies to some extent. Therefore the returns on financial assets will tend to be positively correlated. Nevertheless, there are specific factors associated with some assets which cause the returns on them to be negatively correlated with the returns on other assets, if the effects of economy-wide factors are excluded from the analysis. For example, company X manufactures and sells ice cream. The returns on this activity will obviously be affected by some or all of the economy-wide factors mentioned above, but they will also be heavily dependent on the weather. Company Y is engaged in the manufacture and sale of umbrellas. Like A, the company is affected by economy-wide factors, but its returns are also affected by the weather. Hot and dry weather is good for X and bad for Y, while cold and wet weather is good for Y but not for X. By holding both X and Y in a portfolio, the variability of returns due to the weather is eliminated. In CAPM, a distinction is made between the variability of outcomes brought about by company-specific, i.e. asset-specific, risks, and the variability brought about by general, i.e. market-wide risks. The specific risks are known as 'unsystematic' or 'diversifiable' risks, while the general risks are referred to as 'systematic' or 'nondiversifiable' risks. A basic proposition of CAPM is that no reward can be expected from bearing unnecessary risk. By building an efficient portfolio, the specific or 'unsystematic' risks of individual assets can be diversified away. Therefore an investor holding a single asset or a portfolio consisting of a very small number of assets is bearing unsystematic risk, which could be eliminated by diversification. The investment would not lie on the efficient frontier, and no increase in expected return can result from accepting this risk. Thus the holders of shares in the ice cream company are not rewarded for bearing the specific risks associated with the weather. This risk - the unsystematic risk - could be eliminated by holding shares in companies such as the umbrella manufacturer. Accepting specific risk must therefore be seen as a voluntary act. On the other hand, economy-wide factors which cause variability in investment returns general risk - can only be eliminated by investing in risk-free assets (or by using hedging instruments e.g. options - beyond the scope of this book). The expected returns on risky assets must obviously be higher than the return on risk-free assets to compensate for this unavoidable systematic risk. As we have seen, a rational investor would choose a combination of risky assets along the solid part of the envelope curve in Figure 6.3 - the efficient frontier. All points along this line contain all available risky assets but in differing proportions. Figure shows that an investor with the family of indifference curves IC' would choose the combination of risky assets represented by C', while the combination represented by C" would be chosen by an investor with indifference curves such as IC". Rational investors always seek to reach their highest possible indifference curve. As the shape of indifference curves is not the same for all riskaverse individuals, it follows that any point along the efficient frontier represents a rational choice for some investors.