Beta actually is there to get us to the firm specific risk against the market. So why is it said that investors are thought to hold a well diversified portfolio and don't get compensated for firm specific risk when beta gives that compensation?
I guess I am missing something here...
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Beta represents systematic risk of the company (basically risk associated with the market movements , factors not specific to the company). Beta doesn't account for the company specific risk. That's why CAPM doesn't account for it as well
Very clear, thank you.
You basically answered your own question.....all investors are rational and would hold a well diversified portfolio. Since this would be true for all investors no one would be rewarded for any firm specific risk they take on. CAPM states that the only thing that matters is systematic risk, therefore, having a larger beta would mean a higher expected return of an asset.
Company specific risk reflects economic losses that are gains for another, competing firm. For example, say a company (company A) has a contract with a single customer. If that company was to lose that contract to a competitor (company B), there would be no aggregate change (or it would be minimal) in market dynamics. One company would gain at the expense of the other.
Therefore, if you held both companies as an investor (i.e., were diversified), the loss incurred in company A would be offset by the corresponding gain in company B. An undiversified investor would pay less for company A (i.e., demand a risk premium) while a diversified investor would not. Because the diversified investor is willing to pay more for company A (i.e., does not demand a company specific risk premium), the undiversified investor losses out and is not compensated for the company specific risk. The diversified investor is protected from the company specific risk in company A's operations.
Market risk, however, leads to a secular decline in the industry and in the general economy. In other words, a market risk variable would simultaneously reduce the market values of both company A and company B. Thus diversification cannot fully protect you. The company most sensitive to market risk variables demands a higher premium (i.e., is bought at a discount by ALL market participants). Thus ALL investors are compensated for market risk.
Hope this helps.
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