When we discussed “Capital Market Line”, we saw that if you are willing to bear higher risk (s), you would be rewarded with higher return (E). However, does it mean that if you are willing to invest in a very risky asset, then you will be entitled to have higher expected return? The answer is no!

There are two types of risk, systematic and non-systematic. People are only rewarded for bearing systematic risks but not for non systematic ones! Or saying in a rude way, one will not be rewarded for being ignorant or stupid!

Systematic risks are those non-diversifiable. They are affecting and common to every stock (so, mathematically, the stocks have very good correlations), thus, they are also called “market risks”. This means that if you try to make up a portfolio with more stocks, these risks will still be there because they are common to and highly correlated in all the stocks. For example, in US market, the US economy grow will affect all the US stocks. So, you are not able to diversify this risk.

Non-systematic risks are more “firm-specific”. This means that they only exist in certain companies or industries. For example, when the gas price increases, the auto industry generally suffers but the oil company’s profit will surge. If you hold a portfolio consisting both the auto industry and the oil industry, the effect of gas volatility will be cancelled out! This is diversification. Therefore, non-systematic risk is diversifiable.

For the market portfolio we constructed in Capital Market Line, it is highly diversified (because it contains all equities as mentioned in the video). Therefore, it has no non-systematic risks but only systematic ones! Therefore, you are rewarded if you are willing to bear higher risk (which is purely systematic risks).

However, assume there is a startup company developing a new renewable energy. If they are successful, their stock will surge like rocket. But if they fail, the stocks will become pennies. So, it has very high risk (very high s). However, the investor is not entitled to have high expected return because their risk is very firm specific and can be diversified. If you try to form a portfolio which consists of all the renewable energy companies, you will find that the risk is much lower (because the chance of one of them to be successful is much higher).

So, for me, willing to bear higher market risk for higher expected return is investment. But betting for higher expected return by bearing non-systematic risk is gambling. But I agree, there are no clear distinctions.