What is Relevant Risk?
Also called systematic risk or non-diversifiable risk, relevant risk is the fluctuation of returns caused by the macroeconomic factors that affect all risky assets.
Diversifiable risk is the risk of something going wrong on the company or industry level, such as mismanagement, labor strikes, production of undesirable products, etc.
Relevant risk + Diversifiable risk = Total risk
How Does Relevant Risk Work?
Relevant risk is comprised of the “unknown unknowns” that occur as a result of everyday life. It is unavoidable in all risky investments.
Relevant risk can also be thought of as the opportunity cost of putting money at risk.
For example, Option A is an investment of $100 in a risk-free, FDIC-insured Certificate of deposit. Option B is an investment of $100 in SPY, the ETF that charts the S&P 500 Index. If the expected return on Option A is 1%, and the expected return on Option B is 10%, investors are demanding 9% to move their money from a risk-free investment to a risky equity investment.
The most basic strategy for minimizing relevant risk is diversification. A well-diversified portfolio will consist of securities from different industries with varying degrees of risk. The diversifiable risks will offset one another but some relevant risk will always remain.
Why Does Relevant Risk Matter?
Because of market efficiency, you will not be compensated for the additional risks that arise from failure to diversify your portfolio. This is very important for those who may have a large holding of one stock as part of an employer-sponsored incentive plan. Diversifiable risk exposes you to adverse events on a company or industry level as well as adverse events on a global level.