One bad earnings report can knock 20% off a single stock in a day. If that stock is one of twenty equal holdings, the same report costs your whole portfolio about 1%.
Learning objectives. After this week you can (1) compute an expected return; (2) tell systematic from unsystematic risk; and (3) explain how diversification and correlation reduce risk.
Remember this: diversification shrinks the risk of one company. It cannot remove the risk of the whole market.
1) Expected return
Expected Return = Σ (Probability × Return)
Σ means "add up over every outcome." When the future is uncertain, list the outcomes, weight each by its chance, and add:
| Outcome | Probability | Return |
|---|---|---|
| Good year | 50% | +30% |
| Bad year | 50% | −10% |
| Expected return | 0.5 × 30% + 0.5 × (−10%) = 10% | |
2) Measuring risk
Risk is how far actual returns swing around that expected value. It is measured by the standard deviation, the typical size of those swings. A higher standard deviation means more variable, riskier returns. Two holdings can expect the same return while one swings far more.
3) Two kinds of risk
- Systematic (market) risk hits nearly everything at once: a recession, a jump in interest rates, a crash. It cannot be diversified away.
- Unsystematic (firm-specific) risk hits one company: a factory fire, a lawsuit, a bad earnings report. It can be cut by holding many companies.
Total risk = systematic risk + unsystematic risk.
4) Diversification and correlation
Diversification means spreading money across many holdings so one bad name barely dents the total. It works best when holdings have low correlation, a measure of how two assets move together, running from −1 (exactly opposite) to +1 (exactly together). To see how exposed you are to one name, check its share of the portfolio:
Share of Portfolio = Holding's Value ÷ Total Value
Quick self-check
(a) A 50% chance of +40% and a 50% chance of 0%. Expected return? (b) Is a single company's lawsuit systematic or unsystematic risk? (c) A holding is 25% of your portfolio and falls 20%. How much does the portfolio fall from that alone? (Answers: 20%; unsystematic; 0.25 × 20% = 5%.)
Common mistakes
- Expecting diversification to remove all risk. A crash still pulls almost everything down.
- Counting tickers instead of exposure. Ten stocks in one industry still move together.
- Treating expected return as a promise. It is an average over outcomes, not a forecast.
This week in the arena
In your Holdings table, divide your largest position's Value by your Total value. Then ask: if that one holding fell 20% tomorrow, how much would your whole portfolio fall? Compare that with what a 20% fall in your smallest holding would do. The difference is your firm-specific risk, in your own numbers.