Firm-specific risk is the unsystematic risk associated with a firm and is fully diversifiable according to the theory of finance. An investor can decrease his exposure to firm-specific risk by increasing the number of investments held in his portfolio of stocks. A stock portfolio of around 50 stocks is considered well diversified and contains only the market risk component of the total risk, which is comprised of both the market risk and the firm-specific risk. The idea behind diversification is that the portfolio risk is less than the risk of all individual securities added together.
Estimate the variance of two stocks that you intend to purchase by subtracting the daily returns from the mean returns. Take the square of the difference, then divide by the number of observations.
Calculate the total risk of the two securities in isolation by multiplying the variance of each stock with its weight and adding the results.
Multiply the weights and standard deviations of the two securities by twice the correlation between the two stocks.
Take the square of the weight and standard deviation of stock A and multiply. Repeat the same for stock B and add the two values obtained.
Add the values obtained in Step 3 and Step 4 to obtain the portfolio variance or risk.
Subtract the total risk estimated in Step 2 from the portfolio risk obtained in Step 5. The difference is the firm-specific risk.
Incorporate a large number of stocks into your analysis to diversify the portfolio completely and obtain the best estimate of firm-specific risk for the complete portfolio.
If you intend to estimate the firm-specific risk of individual securities, then follow the two-firm approach through Step 6 and ignore the last step. However, if you intend to value the diversification benefits for holding a portfolio of stocks, follow through Step 7.
The difference between the total risk of holding individual securities and the portfolio risk is always substantial and is used to explain the benefits of diversification.
Calculations for a portfolio with a large number of stocks can complicate your analysis. In this case, it is suggested to use simple financial software instead of performing manual calculations.
- risk and gain image by Photosani from Fotolia.com