You know, by now, that diversification reduces risk. As you add stocks to your portfolio, the total risk drops. But, alas, beyond a certain number of stocks, the total risk ceases to reduce. No one knows what that number is. Warren Buffet’s portfolio never crossed nine stocks. Yet another natty investor Peter Lynch held no less than 1,400 stocks in his armour. But fund managers believe that beyond a point, diversification is meaningless, as the total risk of the portfolio may not ultimately fall to zero.

This brings us to the fact that there are two types of risks; diversifiable risks and non-diversifiable risks.

Diversifiable risks are those that can be reduced through diversification. Remember our example of climate, coffee and soft-drinks? (Business Line dated July 6, 2008). Climate was a diversifiable risk. In fact, by doing both coffee and soft-drinks business, we were able to do away with the risk that climate caused.

Also known as non-systematic risk, diversifiable risks are peculiar to a particular security or a particular industry. Other examples of diversifiable risks are change in management, increase in price of raw materials, competitive pressures, etc.

Non-diversifiable risks are those that cannot be eliminated through diversification. This is an all-pervasive risk that affects companies and industries across the spectrum.

For example, when interest rates rise (as is the scene now) it hurts every stock since equity share holders would want a higher return as their money gets dearer.

Other examples include exchange rate changes (the appreciation of the rupee in recent times hurt exporters); economic slowdown (when US sneezes, the rest of the world catches cold); political instability (the UPA’s fight for survival has seen India’s rating downgraded to negative); ; changes in tax structure (who likes taxes?!) to name just a few.

The stock market does not reward you for undertaking diversifiable risks because you are expected to eliminate them through diversification. You can expect a reward only for bearing non-diversifiable risk.

So how much should be the reward? This is where Beta steps in. Beta measures the sensitivity of a stock with reference to the Sensex. Now, let us say Stock Z has a beta of 1.2. This means that the stock is 20 per cent riskier than the Sensex. It also means that if the Sensex changes by 10 per cent, Stock Z will change by 10 x 1.2 = 12 per cent. And if its beta is 0.7 it means that Stock Z is 30 per cent less risky than the Sensex. If the Sensex changes by 10 per cent, this stock will change by 10 x 0.7 = 7 per cent.

You can now ascertain the rate of return that you should get for buying Stock Z commensurate with the non-diversifiable risk (Beta) that the stock carries.

When you invest, you would like to earn at-least the risk-free rate of return. Say, this is 7 per cent. You would naturally want a premium (extra return) for assuming risks of the stock market. The historical long term return on Sensex across the last 10 years based on monthly average is 16 per cent per annum. This means that stock market investing yields 16 per cent and the risk premium for investing in stocks is 16 - 7 = 9 per cent.

We know that Stock Z is 20 per cent riskier than the Index ( Beta of 1.2) Hence, the risk premium of Z would be 20 per cent higher and therefore 9 x 1.2 = 10.8 per cent. In addition, you would like to earn the risk-free rate of 7 per cent. Therefore the required return on Z Ltd is 10.8 + 7 = 17.8 per cent.

The required return on an investment is the risk free rate plus beta times “risk premium from the market”. How does all this help? Well, if you expect Z Ltd to give you 20 per cent in the next year, then you are looking at a bargain. You get 20 per cent on a stock that needs to give you 18 per cent only. This means that this stock is under valued and should be bought. Alternately, if you expect Z Ltd to give you 15 per cent in the coming year, then it is not worth buying because it needs to give you 18 per cent for the risk undertaken. You just read “Capital Asset Pricing Model”, which helped two gentlemen bag the Nobel Prize in Economics!

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