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Isolating the systematic and unsystematic components of a single stock's (or portfolio's) standard deviation*

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  • Cara M. Marshall

Abstract

This article revisits the roots of modern portfolio theory. Instead of isolating the systematic component of risk by recasting the risk in terms of a stock's beta coefficient, I decompose the SD directly into its systematic and unsystematic components. From this decomposed SD, an 'adjusted capital market line (CML)' can be derived. It is easily shown that the adjusted CML is equivalent to Sharpe's security market line (SML). I evaluate the effectiveness of these alternative measures of systematic and unsystematic risk using empirical data and find that beta often deviates from my systematic risk measure and, in general, tends to overestimate a portfolio's risk. This alternative way of looking at systematic and unsystematic risk offers easily accessible insights into the very nature of risk. Implications include reducing the computational complexities in calculating the relevant portion of a portfolio's volatility, facilitating sophisticated dispersion trades, estimating risk-adjusted returns and improving risk-adjusted performance measurement. This article offers new ideas that may influence the teaching of economics and finance.

Suggested Citation

  • Cara M. Marshall, 2015. "Isolating the systematic and unsystematic components of a single stock's (or portfolio's) standard deviation," Applied Economics, Taylor & Francis Journals, vol. 47(1), pages 1-11, January.
    • Handle: RePEc:taf:applec:v:47:y:2015:i:1:p:1-11
    DOI: 10.1080/00036846.2014.959652
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    Citations

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    Cited by:

    1. Vafai, Nima & Rakowski, David, 2024. "The sources of portfolio volatility and mutual fund performance," International Review of Financial Analysis, Elsevier, vol. 91(C).
    2. Haensly, Paul J., 2020. "Risk decomposition, estimation error, and naïve diversification," The North American Journal of Economics and Finance, Elsevier, vol. 52(C).
    3. M. Volkov & М. Волков, 2018. "Анализ фундаментальной индексации как эффективный подход к активному инвестированию // Analysis of Fundamental Indexation as an Efficient Approach to Active Investing," Review of Business and Economics Studies // Review of Business and Economics Studies, Финансовый Университет // Financial University, vol. 6(4), pages 41-51.

    Replication

    This item has been replicated by:
  • Fabio Pizzutilo, 2015. "Isolating the systematic and unsystematic components of a single stock's (or portfolio's) standard deviation: a comment," Applied Economics, Taylor & Francis Journals, vol. 47(58), pages 6277-6283, December.

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