Question

Question 1:What is the rationale for the positive correlation between risk and expected return?

Question 2: Why is it possible to eliminate unsystematic risk in a well-diversified portfolio? Likewise, why is it not possible to eliminate systematic risk?

Answer 1

(1): There is a positive correlation between risk and expected return and this means that if risk increases then expected returns will also increase and if risk falls then expected return will also fall. The rationale for this positive correlation is that a higher risk investment has a higher potential for profit but also a potential for a greater loss. This positive correlation exists because in case of investments with higher quantum of risks the investors will want more returns to compensate them for bearing that additional risk. Inversely we can say that investments with low risks need not pay higher returns to investors as they are bearing only law quantum of risk. This is why low risky investments like government bonds pay low rate of interest while the returns on equities are high as the associated risks are also higher.

(2): It is possible to eliminate unsystematic risk in a well-diversified portfolio. This is because unsystematic risk is that risk which is inherent in a specific range of company or industry. So when your portfolio adds more companies from different industries the impact of diversification can lead to reduction in unsystematic risk. For example suppose that you hold only shares of aviation companies. When fuel prices rise abnormally the prices of the aviation stocks will fall and you will witness a decline in your holding. But when you add stocks of companies from other industries like Apple, GE, Microsoft then your portfolio will be diversified and the impact of increase in fuel prices will be less pronounced on the valuation of your portfolio.

Systematic risk cannot be eliminated even through diversification. This is because systematic risk pertains to the entire market and not to specific industries. Any economic event will impact all stocks and industries in the same manner. For example if there is increase in inflation or depreciation in currencies or there is an economic recession then all companies and industries will be negatively impacted. It will not matter how well diversified the portfolio is the above mentioned examples of systematic risk will negatively impact all companies and all industries.