Systematic vs. unsystematic risk

Is biotech really that risky?
From Knowledge@wharton

Prior to the discussion, Wharton finance professor Andrew Metrick explained how financial economists view risk by citing two hypothetical companies -- Box Co., an established manufacturer of corrugated boxes, and Drug Co., a biopharmaceutical company. Box Co.'s returns rise and fall with the overall economy, while Drug Co. is working on a cure for a host of diseases, but has little probability of success. Assuming both companies have the same expected cash flow, which company would be expected to generate higher returns for investors? Metrick asked.

He explained that while the drug company has a high level of individual, or idiosyncratic, risk, the box company should offer a premium to investors willing to back it in bad times as well as good. "The box company does well when people are already doing well. It has poor returns when the economy is poor and people are hungry," Metrick noted. "If someone says, 'I will hold Box Co., which will not pay much exactly when I am most hungry,' then they need to be compensated."

Investors in the drug company could mitigate their risk by buying up shares of many drug companies, hoping at least one will come up with a hit product to justify the overall investment.

From the same article. The very important issue of interest versus capability...

He also explained why small venture capital firms take on so much more risk in backing long-shots than do large corporations that have more resources or appear to have the ability to absorb a swing and a miss. Executives and employees at a large company all share in the downside of problems when problems arise at the targeted firm, he said, but the benefits of hitting a home run with a new technology investment are diluted. He noted that even the largest venture capital firms have very few partners, allowing each to win big if a high-risk investment pays off. "These are small organizations. When they get too big, the incentives for any one person aren't so clear," said Metrick. "If someone is better than their partner, then they leave and start their own firm."