Systematic and Unsystematic Risk

WEEK DISCUSSION BOARD 3

Week 4 Discussion Board

1) Diversification is good for shareholders. So why shouldn't managers acquire firms in different industries to diversify a company?

It is important to note that to some extent, diversification does indeed benefit shareholders. This is more so the case given that a move of this nature significantly brings down unsystematic risk. More specifically, in the words of Berk, DeMarzo, and Harfod (2021), “by holding a portfolio of many different investments, investors can eliminate risks that are specific to individual securities” (338). Losses could on this front be significantly reduced because some events impact various categories or industries differently. However, it would be prudent to note that diversification may not sufficiently eliminate systematic risk (Berk, DeMarzo, and Harfod, 2021). Thus, the fact that diversification does indeed benefits shareholders should not be the sole motivator for managers to go on a company acquisition spree in different industries. Further, according to Brigham and Houston (2015), the key success factors may not be related to each other across industries – which would essentially mean that it would be difficult for an enterprise on this front to ensure that functional skills are successfully transferred across the various businesses. This could end up having a negative impact on the effectiveness and performance of a company – thus, hurting shareholder interests. It should also be noted that to a large extent, managers often possess skills and expertise that are largely industry-specific (Brigham and Houston, 2015). Unrelated business diversification could, thus, get in the way of proper leadership and strategic planning. Unrelated diversification could also make it difficult for responsibilities to be shared across diverse roles.

2) Your spouse works for Southwest Airlines and you work for a grocery store. Is your company or your spouse's company more likely exposed to systematic risk? Explain.

In basic terms, systematic risk could be conceptualized as risk that impacts the market in its entirety. More specifically, Berk, DeMarzo, and Harfod (2015) define systematic risk as “fluctuations of a stock’s return that are due to market-wide news” (355). It therefore follows that for a risk to be deemed systematic, it has to affect not just a single company (or stock) but the overall market. In the scenario recounted, my spouse’s company (i.e. Southwest Airlines) would have a greater exposure to systematic risk than my company (i.e. a grocery store). This is more so the case given that in comparison to the food retail industry, the airline industry happens to be much more susceptible to various uncontrollable geopolitical and economic factors which in-turn hugely impact the performance of all individual players. The food retail industry (and by extension individual players) is not as susceptible to the various uncontrollable external factors such as fuel prices, market recession, disease outbreak, etc. This was all too clear through the COVID-19 pandemic peak period. At some point, two thirds of the passenger jets in the world were grounded (Kotoky, Stringer, and Saxena, 2020). The food retail industry was not as affected.