1965-1974
Risk, Market Sensitivity, and Diversification
William F. Sharpe
he notion of risk is central to both security
T analysis and portfolio selection. The primary
source of risk for an individual security is uncer-
tainty about its future price. And the primary
source of risk for a portfolio is uncertainty about its
future market value.
Clearly, some securities are riskier than oth-
ers, and some portfolios are riskier than others.
Moreover, the riskiness of a portfolio is related to
the riskiness of the securities it contains. Few
would quarrel with these statements. To go far-
ther, however, one must adopt quantitative mea-
sures. This paper describes two such measures.
The first, market sensitivity, (or "beta"), has been
advocated by a number of authors z and is being
used increasingly within the investment commu-
nity. 2 The second measure, portfolio diversification,
attempts to make more precise a notion that has
been used for a great many years.
In the remaining sections we will argue: (1)
that much is to be learned about the risk of a
portfolio by measuring its market sensitivity and
diversification, (2) that such measures can be cal-
culated simply, using corresponding measures for
the securities in the portfolio, and (3) that straight-
forward analysis of past data can lead to values of
such measures for securities that will prove useful
in this process.
MARKET AND NON-MARKET RISK
To begin, it is important to divide risk into two
important, but quite different, components. Why
is it difficult to predict the future price of a secu-
rity? Partly, because it is difficult to predict the
future level of the overall market. This source of
risk can be termed the security's market risk. But
even if the future course of the market were
known, some risk would remain. The price of a
security depends at least partly on the fortunes of
the issuer--independent of the course of the mar-
ket or overall economy. This source can be termed
the security's non-market risk.
The market risk of a security or portfolio
Reprinted from Financial Analysts Journal (January~February
1972):74-79.
84
1995, AIMR
depends on the extent to which its price is sensi-
tive to market swings. Our first measure is in-
tended to quantify this relationship.
The non-market risk of a portfolio depends to
a considerable extent on its diversification. Our
second measure is intended to quantify this rela-
tionship. It is designed so that two portfolios with
comparable "diversification" will be likely to have
comparable amounts of non-market risk.
MARKET SENSlTIVFFY
When there is a major change in the market, it is a
rare security indeed that does not go along, to a
greater or lesser extent. A market swing generally
results when investors change their opinions
about the future of the economy. Some companies
are affected more by such changes than are others.
In terms of price action, some securities are more
sensitive to market changes than are others. It is a
relatively simple matter to express this relationship
quantitatively. Consider the following statement:
If the market goes up one per cent more than expected, the
price of XYZ will be percentgreater than expected.
The number used to fill in the blank can be defined
as XYZ's market sensitivity. If the value is less than
1.0, the security is defensive--it moves less than
the typical stock in market swings. On the other
hand, if the market sensitivity is greater than 1.0,
the security is aggressive--it moves more than a
typical stock in market swings.
It is possible to define a number of such
measures: one for a one percent increase in the
market, one for a one percent decrease, one for a
two percent increase, etc. But this would add little
but complexity. It is common practice to use one
number, with the accompanying assumption that
the percentage change in the price of a security
from its expected value is most likely to equal its
market sensitivity times the percentage change in
the market from its expected value.
The market sensitivity of a portfolio is simply
the weighted average of the market sensitivities of
its component securities, using the relative values
as weights. 3 Table 1 provides an example.
Financial Analysts Joumal / January-February 1995
 1965-1974

Table 1. Calculation of a Porffolio's EslJmated Market Sensil~y

Current Number of Current Estimated Relative Value
Market Price Shares in Market Relative Market times Market
Security Per Share Portfolio Value Value Sensitivity Sensitivity
ABC $13.00 1,000 $13,000 .325 .80 .26
DEF 50.00 300 15,000 .375 1.20 .45
GHI 30.00 400 12,000 .300 1.30 .39
$40,000 1.000 1.10
Portfolio Estimated
Market Sensitivity

DIVERSIRCA'RON rifles, each from a different industry. This type of

W h y d o i n v e s t m e n t m a n a g e r s advocate at least
some diversification w h e n constructing a portfo-
lio? Because it can r e d u c e risk. More precisely:
because it can r e d u c e n o n - m a r k e t risk. W h e n one
security does worse t h a n expected (given the mar-
ket's overall behavior), a n o t h e r is likely to do
better than expected. And, generally, the more
securities in a portfolio, the greater the likelihood
that sufficient good fortune will a p p e a r to balance
off the bad fortune.
But it is not quite that simple. The n u m b e r of
securities in a portfolio provides a fairly crude
measure of diversification. Imagine twO portfolios,
each with ten securities. Portfolio A's funds are
divided equally a m o n g its ten securities, but half of
portfolio B's f u n d s are invested in a single security.
Portfolio A w o u l d seem to be m o r e diversified than
portfolio B. To further complicate the matter, some
securities have m o r e n o n - m a r k e t risk than others.
A portfolio of ten securities, each of which has a
large a m o u n t of this type of risk, is likely to offer
less effective diversification than a n o t h e r with ten
securities, each of w h i c h has a small a m o u n t of
n o n - m a r k e t risk.
There are other considerations. For example, a
portfolio of ten chemical securities is likely to offer
less effective diversification than one of ten secu-
difference is difficult to capture in a simple for-
mula. But differences in relative holdings and
securities' n o n - m a r k e t risks can be a c c o m m o d a t e d
quite easily.
The first step requires an estimate of each
security's n o n - m a r k e t risk, relative to that of a
typical security. A value of 1.0 indicates that a
security is typical in this respect. A value of .5
indicates that it has half as m u c h n o n - m a r k e t risk
as a typical security. A value of 2.0 indicates it has
twice as much, etc.
Once such estimates have b e e n obtained, it is
easy to estimate the effective diversification of the
portfolio. Table 2 provides an example.
As the table shows, a n u m b e r of values m u s t
be a d d e d t o g e t h e r - - o n e for each security. Each
value is calculated b y squaring the p r o d u c t of (1)
the relative value invested in the security times (2)
its relative n o n - m a r k e t risk. The s u m (.371 in this
example) is t h e n divided into 1.0 to d e t e r m i n e the
portfolio's diversification. In this case, it is 2.70.
Table 3 provides some insight into the mean-
ing of this measure.
Each security listed in Table 3 provides an
equal p r o p o r t i o n of the portfolio's market value;
moreover, each security is typical with respect to
n o n - m a r k e t risk. A n d the effective diversification

Table 2. Calculation of a Portfolio's Diversification

Current
Market Number of Current (V) (R) Relative
Price Per Shares in Market Relative Non-Market
Security Share Portfolio Value Value Risk VxR (V X R) 2

ABC $13.00 1,000 $13,000 .325 0.5 .163 .027

DEF 50.00 300 15,000 .375 1.0 .375 .141
GHI 30.00 400 12,000 .300 1.5 .450 .203
$40,000 1.000 .371
1
Diversification = . ~ = 2.70

Financial Analysts Joumal / January-February 1995 85

1965-1974

Table 3. Diversification of an Evenly Balanced Rgure 1. The Effect of Diversilicalion on Non-

Portfolio of Typical Securities Market Risk
(V) (R) Relative
o ~" 100
Relative Non-Market
Security Value Risk Vx R (V X R) 2
..~.~
- 75
A .2 1.0 .2 .04
B .2 1.0 .2 .04
C .2 1.0 .2 .04 ~.~ 50
D .2 1.0 .2 .04
E .2 1.0 .2 .04
1.0 .20 ~ 25

1 z~
Diversification = ~ - = 5.0 0 I I I I I I
.2O 10 20 30 40 50 60 70
0
Portfolio Diversification

of the portfolio is 5.0. Thus a portfolio of five

typical stocks, each representing an equal propor-
tion of overall market value, has a calculated
diversification of 5.0.
This example illustrates the interpretation of
the diversification measure:
A balanced portfolio with a diversification of X will have as
m u c h n o n - m a r k e t risk as a balanced portfolio of X securities,
each with a typical a m o u n t of n o n - m a r k e t risk, and each w o r t h
an equal dollar a m o u n t at current market prices. The term
" b a l a n c e d " is included to rule out portfolios with heavy con-
centrations of similar securities. Such portfolios will generally
be less diversified than indicated by the calculation described
here---i.e., they will have more non-market risk.
In cases such as that s h o w n in Table 2, where
a r o u n d n u m b e r is not obtained for diversification,
the result can be interpreted as lying b e t w e e n two
alternatives. Thus a portfolio with a diversification
of 2.70 is less diversified than a portfolio of three
typical securities held in equal proportions; but it is
more diversified t h a n one of two typical securities,
held in equal proportions.
DIVERSlRCA'RON AND NON-MARKET RISK
The non-market risk of a portfolio will, of course,
d e p e n d on more than its calculated level of diver-
sification. However, it is possible to provide a set
of benchmarks for portfolios which have been
designed to avoid u n d u e concentrations of similar
securities. Figure I shows the general relationship.
The vertical axis measures non-market risk relative
to that of a typical security. Thus a portfolio with a
diversification of 1.0 has a full 100 percent of such
risk.
As diversification increases, the a m o u n t of
non-market risk can be expected to decrease, but
not proportionately. Thus a portfolio with a diver-
sification of 4.00 is likely to have 50 percent as
m u c h risk as one with a diversification of 1.00. 4
The basis for this relationship, a n d the choice
of the measure of diversification itself, is described
in the appendix. Here we concentrate on a more
practical question: h o w should the n e e d e d values
for individual securities be estimated?
ESTIMATES FOR SECURmES
Two values are required for every security in a
portfolio: the security's market sensitivity a n d its
relative non-market risk. H o w can such estimates
be obtained? The problem does not differ in a n y
significant w a y from that of estimating, say, future
earnings per share. Careful analysis of past data,
expert knowledge about the firm a n d the industry,
interviews with m a n a g e m e n t , s t u d y of investor
psychology--all these ingredients can be brought
to bear on the problem. But this m a y provide
accuracy that costs more t h a n it is worth. It is
important to remember that the values obtained
for individual securities are to be combined to
calculate comparable values for a portfolio. A n d
the accuracy of a portfolio estimate is far more
important t h a n the accuracy of the individual se-
curity estimates.
A n u m b e r of rather inaccurate estimates for
securities m a y combine to form an exceptionally
accurate estimate for a portfolio, thanks to the law
of large numbers. The estimate for one security
m a y be too high, a n d another too low, with the
result that the average is "just right." To borrow
the statistician's jargon: if predictions about secu-
rities are subject to error but unbiased, s predictions
about fairly well-diversified portfolios m a y be
quite accurate.

86 Financial Analysts Joumal/ January-February 1995


This suggests the possibility of using past data
exclusively to obtain estimates of the relevant at-
tributes of securities. Figure 2 provides an example.
Figure 2. Estimating Market S ~ v i t y
Data
Percentage
Changein
Price of
the Security
11.8%
M a r k e t S e n s i t i v i t y = 0.8
For each of 60 months, the percentage change
in Standard and Poor's 500-stock index is deter-
mined. This represents the overall "market."
Next, the percentage change in the price of the
security in question is calculated for each of the 60
APPENDIX
This paper uses standard statistical measures of
variation to represent risk. The risk of a security is
measured by a standard deviation:
tri = the standard deviation of Ri
Ri = the rate of return on security i
= the percentage price change plus divi-
dend yield
The rate of return on a security is assumed to equal
its yield plus a linear function of the percentage
change in the overall market:
Ri -- Yi + ai + biRm + ci,
where
Yi = the dividend yield on security i
ai = some constant
bi = the market sensitiyity of security i
Rm = the percentage change in the overall
market
Financial Analysts Journal / January-February 1995
1965-1974
months. Then each month is plotted and a straight
line fit through the points (either visually or via
statistical methods). The slope of this line is the
security's market sensitivity.
A useful measure of relative non-market risk
from Past can also be obtained from past data. First, the
statistician's "standard error" is calculated for the
security. 6 Roughly, this is the vertical distance
from the line in a diagram such as Figure 2 within
which two-thirds of the points fall. After the stan-
dard error has been calculated, it is divided by the
standard error for a typical security. 7 The result is
a measure of the security's relative non-market risk.
Several firms produce estimates of market
sensitivity on a continuing basis. Methods differ,
as do names ("beta" and "volatility" are quite
Percentage common). The most accessible source is V a l u e L i n e ,
Changein
S&P500 w h i c h covers 1400 securities. Some brokerage
houses provide coverage of even more (e.g.; Mer-
rill Lynch provides estimates for over 3000 stocks
with monthly updating). At present, values of
relative non-market risk are not quite as accessible.
However, Merrill Lynch provides values from
which they can be readily computed, and uses
them in the manner described here.
No two measures can tell all there is to know
about a po~tfolio's risk. But the relatively simple
measures presented here can greatly increase
one's understanding of the characteristics of a
portfolio. It behooves the thoughtful analyst to
make such calculations.
ci = the difference between the return on se-
curity i and that predicted by its relation-
ship with the Overall market
T h e risk of the security thus depends on two
components:
O-i2 = bi2orm 2 + O-ci21
where
bi2o'm 2 = the market risk of security i
o"m the standard deviation of R m
=
O'c2, = the non-market risk of security i
o-c, = the standard deviation of c i
If the values of the cis for various securities are
independent of one another and of the overall
level of the market 8 the risk of a portfolio will also
depend on two components:
87
1965-1974
where
% = the s t a n d a r d d e v i a t i o n of Rp (the rate of
r e t u r n o n the portfolio)
bp = t h e m a r k e t sensitivity of t h e portfolio
= EXib i
i
Xi = the p r o p o r t i o n of the portfolio's value
invested in security i
The term representing the n o n - m a r k e t risk of the
portfolio can be modified to form the measure of
diversification advocated in the text. Let o'c. repre-
sent a n y more or less arbitrarily chosen "typical"
level of o'ci. T h e n ,
0" ./2
EXi2orci 2 = Orc . 2 E X i 2 v c'
i i \ O'el
T h e t e r m in p a r e n t h e s e s measures
relative n o n - m a r k e t risk:
r i = the relative n o n - m a r k e t risk of s e c u r i t y i
= o'c,O'c.
Diversification is d e f i n e d in t h e text as follows:
1 D = E(xiri)2 = 1
D=
~ ( X i r i ) 2"
i
so t h a t
Exi =o-c. .
i
We take as a specific m e a s u r e of the non-
market risk of a portfolio the standard error of its
r e t u r n . But this is s i m p l y t h e s q u a r e r o o t of the
sum:
FOOTNOTES
1. See W.F. Sharpe, "A Simplified Model for Portfolio Analy-
sis," Management Science (January 1963):277-93; Sharpe, Port-
folio Theory and Capital Markets (New York: McGraw-Hill,
1970); J.L. Treynor, "How to Rate Management of Invest-
ment Funds," Harvard Business Review (January/February
1965):63-75; and Treynor, W.W. Priest, Jr., L. Fisher, and
C.A. Higgins, "Using Portfolio Composition to Estimate
Risk," Financial Analysts Journal (September/October 1968):
93-100.
2. C. Welles, "'The Beta Revolution: Learning to Live with
Risk," The Institutional Investor (September 1971):21-64.
3. See Sharpe, Portfolio Theory and Capital Markets.
4. Well-diversified portfolios have another advantage. In gen-
eral, the greater the diversification, the more accurate will be
88
i
T h e n o n - m a r k e t risk relative to t h a t of a typical
s e c u r i t y is this a m o u n t d i v i d e d b y Crc:, or
1
This is the r e l a t i o n s h i p p l o t t e d in F i g u r e 1.
A n i n t e r p r e t a t i o n of the m e a s u r e of diversifi-
cation is p r o v i d e d b y c o n s i d e r i n g a portfolio of n
stocks, e a c h typical w i t h r e s p e c t to n o n - m a r k e t
risk, a n d e a c h w o r t h t h e s a m e dollar v a l u e . In
other words,
ri = r2 = = rn = 1,
a security's
1
Xi = Xz . . . . . X. = -.
n
Obviously,
1 1
1 1
i n-~+~ + . . . +. n 2
1
If the v a l u e s of the cis are i n d e p e n d e n t , a portfolio
w i t h a diversification of D will t h u s h a v e t h e s a m e
a m o u n t of n o n - m a r k e t risk as o n e w i t h D typical
stocks, h e l d in e q u a l p r o p o r t i o n s (as a s s e r t e d in
t h e text).
the estimate of the portfolio's market sensitivity. In statistical
terms: the standard error of beta is smaller, the smaller the
standard deviation of the residual.
5. And the errors are uncorrelated.
6. See Sharpe, Portfolio Theory and Capital Markets.
7. E.g., the median or average value of the standard errors for
a representative cross-section of securities.
8. This assumption, which has been widely employed, should
prove acceptable in most cases. For further discussion, see
K.J. Cohen and J.A. Pogue, "An Empirical Evaluation of
Alternative Portfolio Selection Models," The Journal of Busi-
ness (April 1967):166-93, and Sharpe, Portfolio Theory and
Capital Markets.
Financial Analysts J o u m a l / January-February 1995