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ing dividends. By contrast, some major insurance claims create huge asso-

ciated legal bills. Every dollar of legal expense serves to reduce the overall

benefit that the portfolio effect could otherwise have brought.

Overall, the effects of correlations, risk capacity and transaction costs are

such as to reduce but not eliminate the potential benefits of the portfolio effect.

For individuals, the potential benefit is very significantly reduced because risk

capacity is so much lower. Large companies, however, can benefit a lot because

they pool together so many risks and they have greater financial strength. At

the top of the tree of those that benefit from the portfolio effect are investors

who invest in shares in large companies. This fact that individuals will benefit

from portfolio diversification to a much lower extent than companies is, in

my view, likely to be the main driving force behind the problem that risk deci-

sions within the corporate environment are not intuitive.

The risk/reward trade off

The capital asset pricing model was introduced earlier in this book. At the

time we had to leave the question of exactly how risk was defined to a later

stage. We did, though, learn about the idea of risk being characterised by the

term Î².24 We are now ready to learn what Î² should represent.

We have previously simply referred to risk and asserted that taking extra

risk needed to be compensated for by the prospect of additional reward. We

had not defined risk and the natural assumption would have been that risk

meant uncertainty. The greater the uncertainty, the greater the required

return, one might have thought. Well, this would have been wrong.

Our chart of how diversification reduces volatility has shown how easy it

is to reduce some of the volatility inherent in owning a share. All an investor

has to do is hold a portfolio of shares and something like half of the volatility

is removed thanks to portfolio diversification. This is not magic, it is just the

way life works. It is so easy to achieve this benefit that it surely cannot be such

as to command an additional return. I would put it another way. I would say

This is the Greek letter Î², pronounced â€˜betaâ€™.

24

167 Building block 5: Risk

that stupidity does not deserve a return and it would be stupid to invest all

your money in a single company.25

The facts are that you can get the same return with much lower risk if you

invest in a wide portfolio of shares rather than just one or two. This is so

easy to do that virtually everybody does exactly that. So when deciding what

reward is necessary in order to entice investors to take risk we need to think

about risk not as it being the total uncertainty associated with the return but

with the contribution to uncertainty that cannot be removed by portfolio

diversification.

If we consider first the risks associated with investing in shares, the meas-

ure of unavoidable risk is a function of the correlation between the returns

on a particular companyâ€™s shares and the returns on the market overall. The

jargon of corporate finance requires that we call this correlation Î². If a 1% rise

on the market is, on average, associated with a 1% rise in the share price of a

particular firm then it is said to have a Î² of 1. If the 1% rise in market prices

is associated on average with a 2% rise in the companyâ€™s share price then that

is a much riskier company and we say it has a Î² of 2.

A Î² of 0 does not mean that a share is not volatile. It simply means that it

is entirely uncorrelated with the overall stock market. It is risk-free to a well

diversified shareholder.

We can therefore return to our chart which depicts the relationship between

risk and required return. For shares we will have a chart that looks like this:

Required

return

rM

rF

Beta

Î²=0 Î² = 1.0

Risk-free Risk of a

typical share

Fig. 5.8 A second look at the capital asset pricing model

Unless of course you had some very good reasons for doing so, such as a desire to control a company

25

or some inside information. Even then, you would still have to think very hard before you did so (and

also watch out for the police if you are trading on inside information!).

168 The five financial building blocks

We can now explain all the parameters of the model as follows:

â€¢ the risk-free rate is referred to as rF;

â€¢ the return required by investors who invest in a portfolio of all the shares

on the stock market is referred to as rM;

â€¢ the line linking these two points is referred to as the security market line;

and

â€¢ risk is characterised by the term Î² which indicates the correlation between

the shares of the company under consideration and the market overall.

This model was postulated as a means for understanding how markets value

shares. It can also help to understand how a company should look at the

individual investment that it makes. If we assume that the company is simply

a means of allowing investors to invest in projects then we can translate the

CAPM model directly to projects and use it to set the appropriate discount

rate for these as well.

In principle, each project has its own Î² which is a reflection of its degree

of undiversifiable risk. Undiversifiable risk is the kind of risk that impacts on

everything. Any risk that is unique or purely random can be diversified away

and so does not impact on the required return.26

We will consider how to set the required return on a project in a lot more

detail in one of the final chapters of this book. For the time being we have

delved deeply enough into this subject to allow readers to make some good

progress and in particular to understand why financial risks may not appear

to take as crucial a role in decision making as one might have expected.

Part 3: Monetising risk

â€˜Risk is impact times probabilityâ€™

In this third part we will learn about a particular technique for making

rational decisions concerning risk. The technique is called risk monetisation.

It involves use of the fact that the financial impact of a risk on value is calcu-

lated by taking the impact of the risk should it come about and multiplying

it by the probability of this happening. It is so useful an approach that many

people actually define risk as being equal to impact times probability.27

Note, however, that although unique risks do not impact on the required return they do impact on

26

the calculation of the expected value cash flows.

Personally I prefer to think of risk as being synonymous with uncertainty, which is why I placed the

27

title of this section in quotation marks.

169 Building block 5: Risk

The statement â€˜risk is impact times probabilityâ€™ is another way to explain

the expected value principle. The expected value of something is the out-

come after all the possible outcomes have been considered and the weighted

value of all possible outcomes has been calculated. So if we had a base case

which reflected what we thought was the expected value outcome but then

realised that we had forgotten about one particular risk, we could establish

the revised â€˜correctâ€™ expected value by adjusting the old base case by impact

times probability for this new factor.

A simple example will show how the approach works. Suppose we are con-

sidering a project with a base case value of $100. Suppose further that this

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