Understanding relationships between return, diversifiable risk and undiversifiable risk

You may have heard of the phrase “risk it for the biscuit”, which basically means, to earn a reward, you must take risks. Sacrificing what you currently own for a better future. This concept applies in many cases in life, financial markets too.

The logic behind “risk and return” is described by the nature of an investment. Essentially, an investment is an action of giving up your money and time with the goal of bringing extra wealth to your life. As we “invest” our time and money, we must be compensated with a “return”. The level of return is dependent on how much “risk (the uncertainty and probability of financial loss)” the investor decides to take on.

A few numbers of risks are:

  • Time: Longer the investment, investors should be compensated with a higher return, this is compensating for the time which the money is gone for
  • Undiversifiable risk: Also known as market risk and systematic risk
    • This risk is unavoidable.
      • Wars
      • Natural disasters
      • Below is the graph of Nikkei 225, a market index for the Tokyo stock exchange from 4thJan 2011 to 29thJuly 2011. On 11thMarch 2011, an earthquake magnitude of 9.0 has ruptured the northeast coast of Japan. The direct economic loss is estimated at USD $360 billion (AUD $533 billion) and nearly 20,000 people died or went missing.
Understanding relationships between return, diversifiable risk and undiversifiable risk
  • Diversifiable risk: Also known as firm specific risk/ sector specific risk and unsystematic risk.
    • This risk is avoidable though diversification
    • Diversification can be used to eliminate firm specific risk
      • An example of an unsystematic risk is oil spill caused in Gulf of Mexico on 20thApril 2010, by a British oil and gas company BP plc. It is recorded as the worst U.S. oil spill in the history. Scientists estimated 184 million gallons were spilled into the ocean and out of the 126 workers at the site, 11 were killed. BP has estimated on 2018, the company paid nearly USD $65 billion (AUD $96.24 Billion).
Understanding relationships between return, diversifiable risk and undiversifiable risk

To highlight the relationships between risk and return and show numerical examples, I have calculated yearly return, risk and beta from 20/08/18 – 19/08/19:

  • The ASX/S&P 200, which is the Australian Stock Exchange Index
  • Cochlear Implant (ASX: COH)
  • The A2 Milk Company (ASX: A2M)

ASX/ S&P 200:

Understanding relationships between return, diversifiable risk and undiversifiable risk
  • Return: 4.2786% per annum
  • Risk (Standard Deviation): 12.8492% per annum
  • Market β (Beta): 1

The ASX/S&P 200 includes largest market capitalised stocks in the Australian Stock Exchange. The ASX/ S&P 200 index is very important, as it is often used as a benchmark for investors and also, shows a general trend of the Australian economy

What is risk (Standard Deviation)?

The risk, also known as a standard deviation, measures the total risk of an investment. The total risk includes both systematic risk and unsystematic risk. The only risk left on the market index is the systematic risk, which cannot be avoided.

*Fun fact, the ASX/ S&P200 Index has recently reached its record high at 6,875.5 points on the 30thJuly 2019.The Aussie Index broke its record closing high of 6,828.7 points, which was set before 2008 global financial crisis, on the 1stNovember 2007. However, on the 15thAugust 2019, the market soon experienced its worst day in 18 months (AUD $63 billion wiped off the market) due to amid fears of a global recession.

Cochlear Implant (ASX: COH)

Understanding relationships between return, diversifiable risk and undiversifiable risk
  • Return: 8.0353% per annum
  • Risk (Standard Deviation): 25.4427% per annum
  • COH β (Beta): 0.8528

Cochlear Implant manufactures hearing devices to assist people with sensorineural hearing loss. During the observed period, COH was able to outperform the market:

  • Return:
    • COH: 8.0353% per annum > ASX:4.2786 per annum

The Risk (Standard Deviation) of COH

COH has a higher standard deviation compared to the market index. This is due to the stock’s “diversifiable risk”, which can be diversified by adding appropriate stocks into your portfolio.

What is Beta?

Beta measures the correlation of a stock compared to the market index. For example, the market index will always have a beta of 1, because it is the market and will always move in the same direction. Whereas a stock with a beta of -1, will move always move inversely to the market. Thus, a stock with a beta of -1, will lose money when the market bullish (positive trending) and make money when the market is bearish (negative trending).

To calculate the beta, I have coupled up the ASX 200 with COH.

The beta of COH has a relatively high correlation with the market. However, the stock does not perfectly follow its price movements. Beta is a crucial component when constructing a well-diversified portfolio.

The A2 Milk Company (ASX: A2M)

Understanding relationships between return, diversifiable risk and undiversifiable risk
  • Return: 31.4595% per annum
  • Risk (Standard Deviation): 37.9749% per annum
  • A2M β (Beta): 1.4861

The A2M Company sources, produces and supplies A2 Brand milk and milk related products in Australia. A2M has the highest risk out of all three and also was able to outperform both securities in the observed period.

When Beta is more than 1:

A2M has a beta higher than the market with 1.4681. This indicates that when the market is bullish, A2M is likely to outperform the index. However, when the market is bearish, it is likely to underperform the index.

Final Critique

From observing three different charts, we were able to identify that riskier an investment is, the graphs have bigger upswings and downswings. Also, the risk and return relationships hold from the investments which we have analysed:

Understanding relationships between return, diversifiable risk and undiversifiable risk

Here is our free, uncomplicated, and extensive ASX portfolio


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The information above is to be used as general investment guidance. Youth Investment Group has no liability for personal financial interests or investment decisions.

Written by associate Jaewon Jung , Youth Investment Group

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