Question

Make distinctions between the standard deviation and beta in the measurement of risk in the capital market. Which one of these two metrics (standard deviation and beta) is relevant for measuring the risk of well-diversified portfolio? Explain why.

Answer 1

An individual investment may have 2 types of risk associated with itself – one is the systematic risk or the market risk, which cannot be diversified or reduced. This could be a risk like increase of income tax rate by government, a new regulation from government that may impede ability to do business of the firms. This risk is measured from Beta.

Other risk is the unsystematic risk associated with the investment. This is residual or diversifiable risk and is unique to the investment. For example, a lawsuit on Amazon from Walmart or from Samsung against Apple, may impact the Amazon or Apple shares/bonds particularly, without any impact on broader market. This kind of risk is diversifiable or can be mitigated by adding different investments in portfolio.

Total Risk (standard deviation) = Systematic Risk (Beta) + Unsystematic Risk

Standard deviation measures total risk associated with the stock or individual asset.

When you are measuring the risk of a well-diversified portfolio, being well-diversified, the unsystematic risk has already been removed and the portfolio will only have market risk inherent in it. So using the measure for market risk, i.e., beta is appropriate.

Standard deviation is more viable measure to check the volatility of individual asset and not a portfolio.