An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk

by Allison Schrager

Idiosyncratic risk can be reduced easily by owning lots of different stocks—any other stock. But a stock that reduces systematic risk is especially valuable, because it is more rare and has the power to reduce risk for your entire portfolio. A stock that moves in a different direction or less strongly than the rest of the market has a low beta, which reduces your systematic risk and makes you safer, so it offers a lower expected return. Conversely, a stock sensitive to the rest of the market, one that goes up 15 percent when the rest of the market only goes up 5 percent, has a high beta. It amplifies systematic risk in your investment portfolio, so you’d only want to buy that stock if you are compensated for taking on more risk. It should promise you a much higher return. If you want to reduce risk in your portfolio, you need lower-beta stocks; if you want higher returns and are comfortable with lots of non-diversifiable risk, you want high-beta stocks.