Total risk is the volatility in the return of an asset. It is often measured using the variance of the stock returns. Variance is the sum of squared difference between the each return and the mean return. The return is measured at regular intervals such as daily, monthly, quarterly or yearly. Variance is an absolute measure of risk. Therefore, it is useful when considering a single stock. However, when comparing returns of different stocks it is better to use the coefficient of variation. The coefficient of variation is a relative measure of risk. It is computed by dividing the standard deviation with the mean.
Total risk comprises of unsystematic risk and systematic risk. Unsystematic risk affects the stock of an individual firm. Systematic risk is the risk that arises from the entire market. Unsystematic risk can be eliminated by diversification. Diversification combines assets with different risks and deviation patterns. A well-diversified portfolio mimics the market and eliminates all unsystematic risk. Systematic risk is measured by the market volatility. It is computed by aggregating the variance of all stocks according to their weights. All stocks that are traded in the market are considered. Systematic risk reflects the performance of the entire market.
Market rewards on systematic risk with higher returns because it represents individual firm’s stocks. A firm with a high risk will also have a high return to compensate investors for assuming additional risk. Therefore, investors can select those stocks that have a high risk that will deliver a high return if they have a large appetite for risk. On the other hand, unsystematic risk combines the averages the risks experienced by all firms in the market. Therefore, the portfolio return is lower than that of an individual high risk stock. This is because it averages high risk stocks that have high return with low risk stocks that have a low return.
References
Khan, W. (2004). Financial Management: Text, Problems And Cases. New York: Tata McGraw-Hill Education.
Shim, J., & Siegel, J. (2008). Financial Management (New ed.). New York: Barron's Educational Series.
