Question

According to Markowitz' Portfolio theory (1952), only market risk should earn a risk premium as idiosyncratic risk can be diversified away. However, newer studies has shown that idiosyncratic risk is priced (Merton, 1987) (Fu, 2009). If idiosyncratic volatility is priced, how can you exploit this fact?

Answer 1

Idiosyncratic risk: Is the risk related to the specific assets or risk which is affect very diminutive number of assets and as per Markowitz' Portfolio theory it can be eradicate by proper diversification of portfolio.

Markowitz' Portfolio theory is based on the Capital assets pricing model which assumes that all the investors holds market portfolio in equilibrium. Markowitz suggest that investors holds portfolio to diversify Idiosyncratic or Unsystematic risk.

Earlier theory expects high systematic risks leads to higher returns and low systematic risk leads to lower return and thus in Capital Assets Pricing Model only systematic risk is priced in equilibrium.

Markowitz thought Idiosyncratic risk is not a bigger concern as we can mitigate it by diversifying our portfolio but yes people say grass is always greener on other side. I mean to say is it is not compulsory whatever assumption we are taking will always holds true. There are various reasons which proves that we can not mitigate the idiosyncratic risk fully and thus its volatility needs to be priced, reasons are as follows:

1) It is not always possible for an investor to have an well diversified portfolio there can be various reasons for that like liquidity of stock, price of stock, policies of stock, preferences of investors or others.

2) Investors having less funds to invest can not invest in more number of securities which in CAPM we do not consider Transaction cost but in real world Transaction cost do exist.

If we pick the past data of investors than we can see less than 10% of investors holds more than 10 stocks in their portfolio, mostly if someone has large number of stocks than it can be related to the company the investor working for. 25 % of investors not hold more than 2-3 no. of stocks and 50% of investors in not more than 4-5 stocks.

Hence, Pricing of volatility of Idiosyncratic risk is important to identify the actual cost of investors over their investments.