Investment Risk Glossary
Uncompensated Investment Risk is “risk that can be eliminated with diversification and unlike systematic or compensated risk, investors cannot expect added return for assuming more uncompensated risk. Uncompensated risk comes from the inherent risk of investments in industry and sector groupings, individual firms and, in addition, having too many of industries/sectors/firms that are closely correlated. Uncompensated risk represents approximately 2/3 of total risk.
Compensated Investment Risk is unavoidable. It is the inherent risk assumed when making any investment. Compensated risk, also known as “undiversifiable risk,” “market risk,” or “systematic risk” because it affects all investments, and is not limited to a particular investment type, security, industry, etc. and investors expect higher returns when assuming more of it. As a result, every participant in the investment market is exposed to it. This compensated risk is both unpredictable and unavoidable. It cannot be changed or diversified away. It changes only when market conditions change. It is considered to be the “price of admission” paid by everyone who becomes a market participant. Compensated risk is approximately 1/3 of total risk.
Note: The source of the estimate of 2/3 of risk attributable to uncompensated risk, and 1/3 of risk attributable to compensated risk comes from Yale Law School Legal Scholarship Repository John H. Langbein, THE UNIFORM PRUDENT INVESTOR ACT AND THE FUTURE OF TRUST INVESTING, 1-1-1996, page 646-7. They cite Brealy at the bottom of page 647 who estimated 69% and 31%. We have rounded it to 2/3 and 1/3.
Diversification Dimensions and Resources OR Eigenfactor Dimensionality (KLD) is a companion metric of CC used to quantify the amount of uncompensated risk removed from a portfolio by diversification. KLD measures the number of independent diversification elements or intrinsic dimensions present in a portfolio. Each dimension represents an element which has the ability to act or move independently within a portfolio’s structure. The larger the number; the greater the ability of each portfolio dimension to perform independently.
Because independent performance is the essence of diversification, when CC is used in combination with KLD, a thorough understanding of uncompensated risk removal is obtained.
Concentration Coefficient (CC) provides a measure of a portfolio concentration and is equal to the number of assets if equally weighted. As concentration increases, the number becomes proportionally less. (E.g. a portfolio with 2 assets, equally weighted at 50% each has a CC of 2; if instead, the weighting changed to 75% and 25%, the CC would be s 1.6). CC is an important diversification metric because of the significance constituent weightings have on a portfolio’s diversification. CC is used in combination with the KLD metric to quantify uncompensated risk removed from a portfolio by diversification. Higher CC values indicate more uncompensated risk removed through diversification.
Alpha is a risk-adjusted measure of the so-called active return on an investment. It is the return in excess of the compensation for the risk borne, and thus commonly used to assess active managers’ performances. The return of a benchmark is subtracted in order to reflect relative performance.
In Finance, Systemic Risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system that can be contained therein without harming the entire system. It refers to the risks imposed by interlinkages and interdependencies where the failure of a single entity or cluster of entities can cause a cascading failure, which could potentially bankrupt or bring down the entire system or market. It is also sometimes erroneously referred to as systematic risk (compensated risk).