There are two very important takeaways from the “equation” of market model of excess return (If you were in a classroom, reconstructing the foregoing “equation” from memory would most certainly be on the next test.) The first takeaway is that portfolios and individual securities have alphas—some positive and some negative. The market and index funds do not have an alpha. The second takeaway is that the “equation” appears to mix apples and oranges: Beta is an estimate of a relationship to the market’s excess return; alpha is an estimate of an amount—the expected risk-adjusted return. For this reason an explicit statement of a security’s characteristics requires estimates of: (1) alpha, (2) beta, and (3) alpha’s variance.
It follows that if a security’s excess return can be broken down into two components—alpha (non-market-related) and beta (market-related)—a security’s risk can also be divided into the same categories. Thus, the risk associated with an investment outcome can be broken into the systematic part and the residual part.
A fundamental fact is that investors expect to be compensated for taking risks. The return derived from investing in the market portfolio is the only return that is earned by suppliers of risk capital. Any risks and returns that are left over after accounting for market risk and market return are known by a variety of names, including residual, nonmarket, unsystematic, and, in the words used by practitioners, stock-selection risk. Stock-selection risk pinpoints the source of the risk as coming from selecting a portfolio that is different from the market portfolio.