low beta implication

From an ans to a treynor-black question, it says the low beta of the active portfolio probably indicates high level of diversifiable risk in the active portfolio, which can be diversified away with the addition of the market portfolio. Beta is a measure of undiversifiable risk. What does it do with diversifiable risk?

not sure whether it answers your question but… SD = total risk SD = nondiversifiable systematic beta risk + diversifiable risk for a given SD, if u have low beta, u would have high diversifiable risk. for that given SD, if u have high beta, u would have a low diversifiable risk

also look at this from the market method angle. var(i) = betai^2 * sigma (market)^2 + error(i)^2 beta i is low, first part is low - so error(i)^2 is high. And that part is the diversifiable risk… which can be diversified away.

Beta measures systematic (market) risk. Beta = 1 --> same risk as the market. Beta < 1 --> less risk than market; ie: large amount of risk that could be diversified away Beta > 1 --> more risk than market; ie: large amount of risk that could NOT be diversified away Random question to anyone reading this: What’s the difference between systematic risk (according to CFAI) and systemic risk (according to “The Street”)?

“Beta < 1 --> less risk than market; ie: large amount of risk that could be diversified away” Could you explain, jdane416? Or the reference to any textbook? I agree that beta less than is less risky than market. But this the systematic risk, which is not diversifiable. The diversifiable risk is reduced by combining uncorrelated assets in a portfolio.

jdane - the systemic risk referred to is that of the banking system…i.e. the risk that the entire banking system would fall apart due to the collapse of ‘systemically important’ institutions such as AIG etc. if a financial institution is systemically important then it is highly likely to be rescued if it falls into difficulties by the government in that jurisdiction. in fact, ratings agencies frequently cite this as one of the reasons for giving such institutions high credit ratings…even though its intrinsic (standalone) quality may be poor

Rodumis - Thanks. All this time I was under the impression the two were the same, but it makes sense now. Jogging - I don’t have any exact reference in the books for this. I’m sure this is talked about somewhere in the PM book though. As for clarification, I think cpk’s reference of using the market method is excellent… I’m not really sure how else to state it. “var(i) = betai^2 * sigma (market)^2 + error(i)^2 beta i is low, first part is low - so error(i)^2 is high. And that part is the diversifiable risk… which can be diversified away.”