The Components of Risk

In the business world risk has various components. For the purposes of this discussion we’ll focus on shareholder return, although the discussion is pertinent to any measure of performance, particularly financial measures. Variations in share price may arise from three distinct sources:

1. Market risk. These are fluctuations driven by movements in the overall market or economy.

2. Industry risk. These risks originate in changes in the performance of the specific industry or sector in which the company operates.

3. Firm-specific risk. This type of risk is associated with performance fluctuations unique to the firm.

Volatility resulting from the first two sources of risk can be called systematic risk.^{[2 ]}Volatility arising from the firm is called unsystematic risk.

Systematic risk is the uncertainty of return associated with the larger system in which an activity takes place. For example, a share of eBay stock is part of the larger market for corporate stock. The ups and downs of that market or system—result from factors over which eBay executives, employees, and company shareholders have no real control. Some of those factors are industry-related. For example, eBay stock is affected by investor sentiment about the Internet-based industry. When investors are disenchanted with that industry, even industry participants that are doing well often take a hit in the value of their shares. Broad, economywide factors that affect share price are also out of management’s control, including consumer confidence, actions of the central bank, changes in tax policy, international conflict, and even terrorism. These factors create a level of volatility in the return of eBay shares as well as that of all other shares in the same “system.” Thus the familiar expression “A rising tide lifts all boats.”

Unsystematic risk, in contrast, is firm-specific. This is the part of a company’s shareholder return that most directly reflects how investors perceive and value the company. It is independent of broader industry and market developments. Some of this volatility, to be sure, is associated directly with factors over which management and employees have control or substantial influence. For example, the success of eBay in implementing its unique strategy, managing costs, and confronting competitors has an impact on the ups and downs of that company’s annual return, as do activities that directly influence investors’ perceptions.^[3]

Why do distinctions between systematic and unsystematic risk matter? Because investors can reduce or eliminate firm-specific risk through diversification: by putting their eggs in many different baskets. By diversifying into different companies and different industries, they can effectively reduce firm-specific risk and industry-specific risk and the costs associated with them. Doing this allows them to reduce their overall risk exposure and the associated cost.^[4] They can balance their portfolios to calibrate risks and expected rewards to meet their objectives and match their individual risk tolerances.

Systematic (market) risk is another story. As long as their capital is in the market, investors are stuck with that component of risk. The only way to reduce market risk is to diversify across different markets, or systems, for example, by putting some capital into stocks, other capital into real estate, and still other capital into collectibles or precious metals.

Employees face a more daunting situation. They do not have real opportunities to diversify their human capital investments. They are stuck with the volatility caused by the market economy, the ups and downs within their industries, and the unique fortunes of their companies. A corporate employee whose monthly pay is linked to company performance (through variable pay) and whose net worth is tied up in company stock options or restricted securities could be dangerously undiversified. If the company has a bad year, variable-pay formulas make that employee’s income shrivel. The employee even may be laid off. If the company collapses, employees like this lose their source of income and watch the value of their stock options and restricted shares melt away. If either the industry or the stock market is in a funk, the value of the employee’s options and shares plummets. This situation imposes a cost on employees that must be compensated. Table 10-1 summarizes the three sources of risk and their impacts on investors and employees.

Table 10-1: How Investors and Employees Differ in Their Ability to Diversify Risk

	Investors	Employees
Market Risk	Not diversifiable within market. Must be compensated.	Not diversifiable (via human capital investments). Executive strategic decisions.—e.g., regarding financial structure—may affect organization’s susceptibility to market fluctuations.
Industry Risk	Diversifiable via portfolio investments in other industries.	Not diversifiable (via human capital investments). Executive strategic decisions—e.g., regarding M&A activity— may affect organization’s susceptibility to industry fluctuations.
Firm-Specific Risk	Diversifiable via portfolio investments in other firms.	Not diversifiable (via human capital investments). But most directly influenced by employee decisions and actions.

Thus, there is a fundamental asymmetry in the positions of investors and employees with respect to the ability to bear risk. Investors can reduce risk through diversification in capital markets; that’s the very reason capital markets exist. Employees are stuck with their risks. Labor markets afford no such opportunity for effective diversification. Investors therefore are positioned better to bear such risk, and at a lower cost compared with employees. This is generally true, but with two essential caveats. First, not all forms of risk can be diversified effectively through capital markets, as was indicated above. Second, the requirements for optimal risk management are often at odds with the requirements for delivering effective performance incentives, especially when it is difficult to observe the actual contributions of employees directly.

From a risk-sharing point of view, this situation seems to argue for firm-specific risk to be shifted entirely to investors, but that would not be a great idea. Since part of firm-specific volatility originates in the decisions and actions of executives and other employees, allocating risk completely to investors would give employees no incentives to perform well. This is the age-old insurance problem of moral hazard.^[5] Insure the individual completely against losses, and the likelihood that losses will occur rises as diligence falls. That is why there are deductibles in insurance policies. Part of the risk must remain with the insured. This explains the need to have employees bear part of the risk associated with firm-specific performance. Indeed, incentives are strongest when they are linked to the firm-specific component of volatility.

Unfortunately, there is no optimal solution to the risk-sharing problem, only a difficult trade-off. Risk sharers are in what economists call a “second-best” world in which efficient risk sharing and optimal performance incentives cannot be achieved simultaneously. Doing better with one usually means compromising on the other. What is the solution? As usual in this book, measurement is the key. There may be no perfect solution, but the better able a company is to determine the sources of risk and weigh their relative impacts on performance variations, the better able it will be to mediate the tension between balancing risk and providing incentives. Before decisions can be made on how to allocate risk, it is essential to assess and measure its sources.

^{[2 ]}We recognize this definition is different from that commonly used in the traditional theory of finance. Financial economists adopt a purely investors’ perspective, classifying as “systematic risk” only the part of stock price variation that is driven by the market. The remaining variation is classified as “unsystematic.” In our discussion, we look at risk from the perspective of all stakeholders who “invest” in the company. We need a definition or taxonomy flexible enough to incorporate the perspectives of employees as well. Certainly, variations in stock price driven by movements in market and industry performance are “systematic” from the employee’s vantage point. These movements together affect the employee’s cost of bearing performance risk.

^[3]Some firm-specific risk is more random in nature. A takeover rumor, for example, can send the stock price gyrating even if it is completely unfounded. Yes, management can act to quell the rumor. But the effects will show up in the volatility we measure and certainly represent “risk” from both the investor and employee perspectives.

^[4]For risk reduction through diversification to work, the assets added to the portfolio must not be highly correlated. For example, adding the shares of a particular regional bank to a portfolio composed entirely of regional banks would result in very little risk reduction, since the movement of shares of these firms is positively correlated to a high degree.

^[5]There is an extensive literature on the economics of incentives and risk sharing that characterizes the moral hazard problem, the conditions under which it arises, and alternative solutions. That literature is summarized in H. R. Nalbantian. “Incentive Compensation in Perspective.” In H. R. Nalbantian, ed., Incentives, Cooperation and Risk Sharing: Economic and Psychological Perspectives on Employment Contracts. Totowa, NJ: Rowman & Littlefield, 1987, 3–43.
Among the most important individual contributions are:
• B. Holmstrom, “Moral Hazard and Observability,” The Bell Journal of Economics, 1979, 10: 74–91.
• S. A. Ross, “The Economic Theory of Agency: The Principal’s Problem.,” American Economic Review, 1973, 63: 134–139.
• S. Shavell, “Risk Sharing and Incentives in the Principal and Agent Relationship,” The Bell Journal of Economics, 1979, 10: 55–73.
• J. E. Stiglitz, “Incentives and Risk Sharing in Sharecropping,” Review of Economic Studies, 1974, 41: 219–256.
• J. E. Stiglitz, “Incentives, Risk and Information: Notes Towards a Theory of Hierarchy,” The Bell Journal of Economics, 1975, 6: 552–579.
• J. E. Stiglitz, “Risk, Incentives and Insurance: The Pure Theory of Moral Hazard,” The Geneva Papers on Risk and Insurance, 1983, 8: 4–33.