Why do investors not get compensated for diversifiable risk?

One of the tenets of modern finance is that risk is seen from the perspective of the marginal investor[1]. In publicly traded firms, it is highly likely that the marginal investor is well diversified[2] and hence concerned about only about market risk[3]. It follows therefore, that all investors must also consider only market risk no matter how concentrated and undiversified their own portfolios are.

The natural question for me has always been that why should an investor not look at risk from his own perspective? If he has a concentrated portfolio, should he not demand compensation for firm-specific risk in addition to market risk?

We all know that the answer is no. But do we know why? There are two reasons for this:

1. Investors who consider total risk are likely to lose out (on investing in a firm) to those who consider only market risk, other things remaining the same; and

2. Managers of the firm may themselves consider only market risk when evaluating projects for the firm to invest in.

Both of the above reasons can be better explained with the help of the following examples.

The reasons why

Consider total risk and lose out[4]

Let’s take the case of two investors — Investor C (concentrated portfolio) and Investor D (well diversified) — who are analysing the same firm to invest in. Suppose they come up with the same expectations in terms of earnings, reinvestments, cash flows and risk for the firm. The only difference, however, is that Investor D is concerned only with market risk whereas Investor C is concerned with total risk. In spite of same expectations, they will both get different values for the firm., with Investor D willing to pay a higher price. This is because Investor D’s expected return/ cost of capital will be lower than Investor C.

Therefore, in a market where there are many diversified investors competing with each other to invest in firms, the undiversified investor will likely be left empty-handed if he keeps demanding compensation for total risk.

Managers may themselves consider only market risk

Let’s say that managers of a publicly traded firm are analysing new projects and have to choose a discount rate for their capital budgeting exercise — a 20% rate which reflects the total risk of the project (including project-specific risk) or a 12% rate which reflects only market risk.

Managers may be tempted to use the higher rate because they want to adequately compensate for the total risk of the project. But think about this from the perspective of the firm’s largest investors[5], who are well diversified. Since they don’t face any firm-specific risk, using a higher discount rate would mean foregoing projects which could otherwise add value to the ‘diversified’ investors of the firm. Accordingly, they would rather have the managers use the 12% rate instead of 20%.

If the managers continue to remain conservative and use total risk, investors could try and replace the board of directors of the firm. If, however, they are unable to do so, they could sell their shares, thereby pushing the firm’s stock price down. And to the extent that managers are evaluated based on stock price performance, they may be more willing to mend their ways and start considering market risk.

Once the company itself considers only market risk for its own projects, it is logical for small, undiversified investors to expect compensation for this portion of risk only. This is because these investors are not in a position to alter the decision-making powers of the managers of the company.

To conclude

Not being diversified is an investors’ own problem (which he can easily rectify) and the market is not kind enough to compensate him for it. Small investors are price takers and thus, have to accept compensation only for the risk that marginal investors see in the firm.

[1] Professor Aswath Damodaran defines a marginal investor as someone who:

· Owns a lot of stock; AND

· Is most likely to trade on the stock.

[2] In most publicly traded companies, investors who fulfil both of the above conditions are likely to be institutions. And since institutions are generally well diversified, they are worried about only market risk.

[3] Risk that cannot be diversified away, also known as systematic risk. This is the risk that affects most firms in a market such as, interest rates, inflation, GDP growth, etc.

[4] Damodaran, Aswath. Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, Third Edition, pp. 65.

[5] The reason that you have to take the perspective of the investors is that they are the owners of the firm and it is their money that is at stake. Managers merely operate the company on behalf of the investors.