📚 PASS Research Analyst Certification Examination Difficulty: Intermediate ℹ️ Info   ~5 min read
📌 Chapter 12.9 — Calculating risk adjusted returns:

Imagine you are drafting an investment committee note for a mid-cap fund. You notice that while the portfolio has historically outperformed the Nifty 50, its total volatility—measured by standard deviation—is significantly higher than the benchmark. To determine if this risk is justified, you must decompose the risk profile: how much of this fluctuation comes from the broader Indian macroeconomic environment, and how much is specific to the poor selection of individual stocks? This is the fundamental distinction between systematic and unsystematic risk.

Systematic risk, often termed market risk, represents the hazards inherent to the entire market or economy. Factors such as shifts in RBI interest rate policies, changes in corporate tax rates, or sudden geopolitical tensions cannot be avoided through diversification. Because this risk affects every participant in the Indian equity market, investors cannot eliminate it by adding more stocks to their holdings. Consequently, the market compensates investors for bearing this unavoidable uncertainty, and we measure it using Beta.1

In contrast, unsystematic risk is unique to a specific firm or industry, such as a localized labor strike, a failed product launch, or poor management execution. This risk is diversifiable; by constructing a well-balanced portfolio across sectors like IT, banking, and FMCG, the negative shocks to one company can be offset by the gains or stability of others. An analyst must realize that for a well-diversified portfolio, unsystematic risk approaches zero.

If a portfolio manager is consistently taking on excessive unsystematic risk without a commensurate increase in returns, they are failing to leverage the primary benefit of portfolio construction: the elimination of non-rewarded risk.

Effective research involves recognizing that your recommendation should only account for systematic risk when assessing required returns. When building a DCF model or evaluating an alpha strategy, you should aim to minimize unsystematic risk through intelligent allocation. If you find that a client’s portfolio is heavily concentrated in a single sector, you are likely exposing them to significant unsystematic risk that provides no extra ‘market’ premium. By shifting the focus toward systematic exposure, you provide a more robust, risk-adjusted path for your client’s capital.

Nuance

⚠️ Nuance
Many candidates incorrectly assume that ’total risk’ is the primary metric for all portfolios. In reality, while total risk (measured by standard deviation) is vital for a concentrated retail portfolio, a professional analyst managing a broad mandate focuses on systematic risk because unsystematic risk should have been ‘diversified away.’ The pitfall lies in using the Sharpe Ratio (total risk) for a well-diversified institutional fund when the Treynor Ratio (systematic risk) is the theoretically superior tool for judging the manager’s skill in managing systematic market exposure.

Check Your Understanding

Practice Question 1

An analyst is evaluating a portfolio that is highly diversified across 50 stocks from various sectors in the Indian market. Which statement accurately describes the risk profile of this portfolio?

Practice Question 2

Why should a research analyst prefer the Treynor Ratio over the Sharpe Ratio when evaluating a well-diversified institutional equity portfolio?

This is a companion read for Section 12.9 — Calculating risk adjusted returns: from PASS Research Analyst Certification Examination by Akhilesh Gururani, available on Amazon Kindle.

Copyright © 2026 Akhilesh Gururani. All rights reserved.

  1. Beta is the sensitivity of an asset’s returns to the market’s returns. A beta of 1.0 implies the asset moves in lockstep with the Nifty, while a beta above 1.0 indicates heightened sensitivity to systematic market swings. ↩︎