244 Part 3 Financial Assets
Market risk is the risk that remains even if the portfolio holds every stock in
the market. Market risk is the risk that we discussed in the opening vignette
and in our discussion of Figure 8-1.- Diversi" able risk is caused by such random, unsystematic events as lawsuits,
strikes, successful and unsuccessful marketing and R&D programs, the win-
ning or losing of a major contract, and other events that are unique to the par-
ticular " rm. Because these events are random, their effects on a portfolio can
be eliminated by diversi" cation—bad events for one " rm will be offset by
good events for another. Market risk, on the other hand, stems from factors
that systematically affect most " rms: war, in! ation, recessions, high interest
rates, and other macro factors. Because most stocks are affected by macro fac-
tors, market risk cannot be eliminated by diversi" cation. - If we carefully selected the stocks included in the portfolio rather than adding
them randomly, the graph would change. In particular, if we chose stocks with
low correlations with one another and with low stand-alone risk, the portfo-
lio’s risk would decline faster than if random stocks were added. The reverse
would hold if we added stocks with high correlations and high #s. - Most investors are rational in the sense that they dislike risk, other things held
constant. That being the case, why would an investor ever hold one (or a few)
stocks? Why not hold a market portfolio consisting of all stocks? There are several
Market Portfolio
A portfolio consisting of
all stocks.Market Portfolio
A portfolio consisting of
all stocks.A B C D E F G
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138Rate of Return (%)-20% 15% 40%Rate of Return (%)-20% 15% 40%Portfolio WYStocks W and Y, held separatelyYear Stock W Stock Y Portfolio WY
2004
2005
2006
2007
2008
Avg return =
Estimated! =40.00%
-10.00
35.00
-5.00
15.0040.00%
15.00
-5.00
-10.00
35.0040.00%
2.50
15.00
-7.50
25.00
15.00%
22.64%15.00%
22.64%15.00%
18.62%
Correlation coe$cient = 0.352004 2005 2006 2007 2008WYRate of Return-15%0%15%30%45%WYF I G U R E 8! 5 Returns With Partial Correlation, %^ $^ " 0.35