diversified portfolio is a much smaller percentage of that
portfoliothanwouldbethecaseifyouwerenotdiversified.
Thus,anyactionthatincreasesordecreasesthevalueofonly
that investmentor a smallgroup of investments willhave
only a smallimpact onyour overallportfolio. Thesecond
reasonisthattheeffectsoffirm-specificactionsontheprices
ofindividualassets ina portfoliocanbe eitherpositive or
negativeforeachassetforanyperiod;somecompanieswill
deliver good news whereas others will deliver bad news.
Thus,in verylarge portfolios,this riskwillaverage outto
zero(at leastover time) and willhavelittle effect on the
overall value of the portfolio. In contrast, the effects of
marketwidemovementsarelikelytobeinthesamedirection
formostorallinvestmentsinaportfolio,thoughsomeassets
maybeaffectedmorethanothers.Forinstance,otherthings
beingequal,anincreaseininterestrateswilllowerthevalues
ofmostassetsinaportfolio.Beingmorediversifieddoesnot
eliminate this risk.
Step 3: Assume the Marginal Investor Is Well Diversified
The argument that diversification reduces an investor’s
exposuretoriskisclearbothintuitivelyandstatistically,but
riskandreturnmodelsinfinancegofurther.Themodelslook
at riskthrough theeyes of the investormost likely to be
trading on the investment at any point in time (i.e., the
marginalinvestor).They arguethatthis investor,who sets
pricesforinvestments,iswelldiversified;thus,theonlyrisk
thatheorshecaresaboutistheriskaddedontoadiversified
portfolio or market risk. Is this a realistic assumption?
Consideringthefactthatmarginalinvestorshavetoownalot
ofstockandtradeonthatstock,itisverylikelythatweare
talking about an institutional investor—mutual fund or