Portfolio Diversification
Investors in the stock market typically like to reduce the risk of
their portfolios. This risk—typically measured with a statistical
concept called the standard deviation—can be reduced by
purchasing the stocks of several different companies rather
than just one or two. However, the mathematics of finance
shows that the greatest reduction in risk is achieved when you
increase the number of individual stocks from one to two. After
this point, adding more stocks still reduces risk but at a
decreasing rate. These diminishing marginal returns to
reducing risk have led many investment advisers to suggest
that a sensible portfolio should contain stocks from no more
than 15 to 20 well-chosen companies.
- For a given stock of fish and increasing numbers of boats, this
example is a good illustration of the law of diminishing returns.
But in recent years the story has become more complicated as
overfishing has depleted the stock of fish. We examine the
reasons for overfishing in Chapter 16 .