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How does the magnitude of firm specific risk affect the extent to which an active investor...

How does the magnitude of firm specific risk affect the extent to which an active investor will be willing to depart from an indexed portfolio?

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Answer #1

The total risk for an individual stock is the sum of index risk (market index, M) and firm specific risk :

i2 = i2M2+ 2(i) where, total risk for market index is M2

The investor is only compensated for incurring index risk (market risk) and not firm specific risk since other investors can easily eliminate the risk through diversification and without any cost. Therefore a well diversified investor will pay more for the stock decreasing the stocks return to compensate only for index risk.

The greater the firm specific risk of an asset,the smaller its position in optimal risky portfolio (total risk). Increased firm specific risk (2(i)) reduces the extent to which an active investor will be willing to depart from an indexed portfolio and will buy an individual stock.

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