Let's take a look at the two basic types of risk:

Systematic Risk - Systematic risk influences a large number of assets. A significant political
event, for example, could affect several of the assets in your portfolio. It is virtually impossible to
protect yourself against this type of risk.

Unsystematic Risk - Unsystematic risk is sometimes referred to as "specific risk". This kind of
risk affects a very small number of assets. An example is news that affects a specific stock such
as a sudden strike by employees. Diversification is the only way to protect yourself from
unsystematic risk.

What is 'Systematic Risk'?

The risk inherent to the entire market or an entire market segment. Systematic risk, also known as
undiversifiable risk, volatility or market risk, affects the overall market, not just a particular stock or
industry. This type of risk is both unpredictable and impossible to completely avoid. It cannot be mitigated
through diversification, only through hedging or by using the right asset allocation strategy.

For example, putting some assets in bonds and other assets in stocks can mitigate systematic risk
because an interest rate shift that makes bonds less valuable will tend to make stocks more valuable, and
vice versa, thus limiting the overall change in the portfolios value from systematic changes. Interest rate
changes, inflation, recessions and wars all represent sources of systematic risk because they affect the
entire market. Systematic risk underlies all other investment risks.

The Great Recession provides a prime example of systematic risk. Anyone who was invested in the
market in 2008 saw the values of their investments change because of this market-wide economic event,
regardless of what types of securities they held. The Great Recession affected different asset classes in
different ways, however, so investors with broader asset allocations were impacted less than those who
held nothing but stocks.

If you want to know how much systematic risk a particular security, fund or portfolio has, you can look at
its beta, which measures how volatile that investment is compared to the overall market. A beta of greater
than 1 means the investment has more systematic risk than the market, less than 1 means less
systematic risk than the market, and equal to one means the same systematic risk as the market.

Whereas this type of risk affects a broad range of securities, unsystematic risk affects a very specific
group of securities or an individual security. Unsystematic risk can be mitigated through diversification.
What is 'Unsystematic Risk'?
Company- or industry-specific hazard that is inherent in each investment. Unsystematic risk, also known
as nonsystematic risk, "specific risk," "diversifiable risk" or "residual risk," can be reduced
through diversification. By owning stocks in different companies and in different industries, as well as by
owning other types of securities such as Treasuries and municipal securities, investors will be less
affected by an event or decision that has a strong impact on one company, industry or investment type.
Examples of unsystematic risk include a new competitor, a regulatory change, a management change
and a product recall.

For example, the risk that airline industry employees will go on strike, and airline stock prices will suffer as
a result, is considered to be unsystematic risk. This risk primarily affects the airline industry, airline
companies and the companies with whom the airlines do business. It does not affect the entire market
system, so it is an unsystematic or nonsystematic risk.

An investor who owned nothing but airline stocks would face a high level of unsystematic risk. By
diversifying his or her portfolio with unrelated holdings, such as health-care stocks and retail stocks, the
investor would face less unsystematic risk. However, even a portfolio of well-diversified assets cannot
escape all risk. It will still be exposed to systematic risk, which is the uncertainty that faces the market as
a whole. Even staying out of the market completely will not take an investors risk down to zero, because
he or she would still face risks such as losing money from inflation and not having enough assets to retire.

Investors may be aware of some potential sources of unsystematic risk, but it is impossible to be aware of
all of them or to know whether or when they might occur. An investor in health-care stocks may be aware
that a major shift in government regulations could affect the profitability of the companies they are
invested in, but they cannot know when new regulations will go into effect, how the regulations might
change over time or how companies will respond.

What is the 'Capital Asset Pricing Model (CAPM)?

The capital asset pricing model (CAPM) is a model that describes the relationship between risk
and expected return and that is used in the pricing of risky securities.
The general idea behind CAPM is that investors need to be compensated in two ways: time value of
money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and
compensates the investors for placing money in any investment over a period of time. The other half of
the formula represents risk and calculates the amount of compensation the investor needs for taking on
additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to
the market over a period of time and to the market premium (Rm-rf).

The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security
plus a risk premium. If this expected return does not meet or beat the required return, then the investment
should not be undertaken. The security market line plots the results of the CAPM for all different risks
(betas).

Using the CAPM model and the following assumptions, we can compute the expected return of a stock in
this CAPM example: if the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the expected
market return over the period is 10%, the stock is expected to return 17% (3%+2(10%-3%)).

No matter how much we diversify our investments, it's impossible to get rid of all the risk. As investors, we
deserve a rate of return that compensates us for taking on risk. The capital asset pricing model (CAPM)
helps us to calculate investment risk and what return on investment we should expect. Here we look at
the formula behind the model, the evidence for and against the accuracy of CAPM, and what CAPM
means to the average investor.

Birth of a Model
The capital asset pricing model was the work of financial economist (and, later, Nobel laureate in
economics) William Sharpe, set out in his 1970 book "Portfolio Theory And Capital Markets." His model
starts with the idea that individual investment contains two fundamental types of risk:

1. Systematic Risk - These are market risks that cannot be diversified away. Interest rates,
recessions and wars are examples of systematic risks.
2. Unsystematic Risk - Also known as "specific risk," this risk is specific to individual stocks and
can be diversified away as the investor increases the number of stocks in his or her portfolio. In
more technical terms, it represents the component of a stock's return that is not correlated with
general market moves.
Modern portfolio theory shows that specific risk can be removed through diversification. The trouble is
that diversification still doesn't solve the problem of systematic risk; even a portfolio of all the shares in the
stock market can't eliminate that risk. Therefore, when calculating a deserved return, systematic risk is
what plagues investors most. CAPM, therefore, evolved as a way to measure this systematic risk.

The Formula

Sharpe found that the return on an individual stock, or a portfolio of stocks, should equal its cost of
capital. The standard formula remains the CAPM, which describes the relationship between risk and
expected return.

Here is the formula:

CAPM's starting point is the risk-free rate - typically a 10-year government bond yield. To this is added a
premium that equity investors demand to compensate them for the extra risk they accept. This equity
market premium consists of the expected return from the market as a whole less the risk-free rate of
return. The equity risk premium is multiplied by a coefficient that Sharpe called "beta."

Beta
According to CAPM, beta is the only relevant measure of a stock's risk. It measures a stock's
relative volatility - that is, it shows how much the price of a particular stock jumps up and down compared
with how much the stock market as a whole jumps up and down. If a share price moves exactly in line
with the market, then the stock's beta is 1. A stock with a beta of 1.5 would rise by 15% if the market rose
by 10%, and fall by 15% if the market fell by 10%.

Beta is found by statistical analysis of individual, daily share price returns, in comparison with the market's
daily returns over precisely the same period. In their classic 1972 study titled "The Capital Asset Pricing
Model: Some Empirical Tests," financial economists Fischer Black, Michael C. Jensen and Myron
Scholes confirmed a linear relationship between the financial returns of stock portfolios and their betas.
They studied the price movements of the stocks on the New York Stock Exchange between 1931 and
1965.

Beta, compared with the equity risk premium, shows the amount of compensation equity investors need
for taking on additional risk. If the stock's beta is 2.0, the risk-free rate is 3% and the market rate of return
is 7%, the market's excess return is 4% (7% - 3%). Accordingly, the stock's excess return is 8% (2 X 4%,
multiplying market return by the beta), and the stock's total required return is 11% (8% + 3%, the stock's
excess return plus the risk-free rate).

What this shows is that a riskier investment should earn a premium over the risk-free rate - the amount
over the risk-free rate is calculated by the equity market premium multiplied by its beta. In other words, it's
possible, by knowing the individual parts of the CAPM, to gauge whether or not the current price of a
stock is consistent with its likely return - that is, whether or not the investment is a bargain or too
expensive.

This model presents a very simple theory that delivers a simple result. The theory says that the only
reason an investor should earn more, on average, by investing in one stock rather than another is that
one stock is riskier. Not surprisingly, the model has come to dominate modern financial theory. While
some studies raise doubts about CAPM's validity, the model is still widely used in the investment
community. Although it is difficult to predict from beta how individual stocks might react to particular
movements, investors can probably safely deduce that a portfolio of high-beta stocks will move more than
the market in either direction, or a portfolio of low-beta stocks will move less than the market. This is
important for investors - especially fund managers - because they may be unwilling to or prevented from
holding cash if they feel that the market is likely to fall. If so, they can hold low-beta stocks instead.
Investors can tailor a portfolio to their specific risk-return requirements, aiming to hold securities with
betas in excess of 1 while the market is rising, and securities with betas of less than 1 when the market is
falling.

Not surprisingly, CAPM contributed to the rise in use of indexing - assembling a portfolio of shares to
mimic a particular market - by risk averse investors. This is largely due to CAPM's message that it is only
possible to earn higher returns than those of the market as a whole by taking on higher risk (beta).

The security market line ("SML" or "characteristic line") graphs the systematic (or market) risk versus the
return of the whole market at a certain time and shows all risky marketable securities. The SML
essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents
the risk (beta), and the y-axis represents the expected return. The market risk premium is determined
from the slope of the SML. The security market line is a useful tool for determining whether an asset
being considered for a portfolio offers a reasonable expected return for risk. Individual securities are
plotted on the SML graph. If the security's risk versus expected return is plotted above the SML, it is
undervalued because the investor can expect a greater return for the inherent risk. A security plotted
below the SML is overvalued because the investor would be accepting less return for the amount of risk
assumed.
Conclusion
The capital asset pricing model is by no means a perfect theory. But the spirit of CAPM is correct. It
provides a usable measure of risk that helps investors determine what return they deserve for putting
their money at risk.

(Source: Investopedia)