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Understanding Company, Sector or Industry Risk
[By Julia O’Neal; MA, CPA]
Unsystematic risks are those associated with factors particular to the underlying company, sector or industry.
Unsystematic risks are all risks that can be eliminated by diversification and are thus unrewarded.
The Alpha Factor
The residual nonmarket influences unique to each stock are measured by its alpha factor.
When one stock has a higher or lower rate of return than another stock with the same beta, this is said to be a result of its alpha factor. If the physician-investor can pick enough stocks with positive alphas, the portfolio can be expected to perform better than its beta would have indicated for a given market movement.
Diversification
Unsystematic risk is reduced through diversification.
As more stocks are added to a portfolio, the chance of obtaining a positive alpha, as well as the risk of getting a negative alpha, is diversified away. The volatility of the portfolio becomes much like the market itself.
Assessment
Therefore, a fully diversified portfolio – if there is such a thing – has a beta of 1.0 and an alpha of 0. Is your portfolio appropriately diversified; or is it di-worsified?
Conclusion
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