In 1952 a graduate student named Harry Markowitz argued that no investment should be judged on its own. Four decades later his idea became the legal test of prudence for trustees. It now sits behind almost every portfolio an adviser builds.
Clients want to know how risky an investment is. The usual yardstick is standard deviation, which measures how widely returns swing around their average. It captures total risk, and capital market theory splits that total into two pieces.
- Systematic risk: This is market risk. It hits nearly every security at once through recessions, interest rate changes, inflation or political shocks.
- Unsystematic risk: This is company-specific or industry-specific risk, such as a failed drug trial or an accounting fraud.
Total risk equals systematic plus unsystematic risk. Market (systematic) risk is the part which diversification cannot remove, and company-specific unsystematic risk is the part which it can. Each holding you add from another company or industry lets one firm's bad news offset another's good news.
Common mistakes
- Jensen's alpha with expected returns: Grading the 0.9-beta fund against an expected 10% market return gives a 9.3% benchmark and an alpha of −7.3. The actual market return of −10% gives the correct +10.7.
- Swapping the CML and SML: If the horizontal axis is standard deviation, the line is the CML; if it is beta, it is the SML.
- Overstating the weak form: The weak form defeats only technical analysis. A stem saying fundamental analysis fails describes the semi-strong form or stronger.
Bottom line
- Total risk (standard deviation) equals systematic risk, which diversification cannot remove, plus unsystematic risk, which it can; only systematic risk earns a premium.
- Beta measures systematic risk against the market's 1.0: above 1 moves more, below 1 moves less, below zero moves opposite, and portfolio beta is the weighted average.
- CAPM required return = risk-free rate + beta × (expected market return − risk-free rate), assuming rational investors, a single period and unlimited borrowing and lending at the risk-free rate.
- The SML plots required return against beta; expected return above it means undervalued (positive alpha), below it overvalued; Jensen's alpha uses the actual market return.
Exam shortcut
Read the risk measure in the stem before anything else. Beta points to CAPM, the SML or the Treynor ratio; standard deviation points to the CML, the efficient frontier or the Sharpe ratio. On any CAPM item, subtract the risk-free rate from the market return before multiplying by beta. Expect a planted answer equal to beta times the whole market return.
The full lesson (about 4,419 words, 29 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- C21
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