Chapter 7 • Portfolio theory and its relevance to real investment decisions
Two features might surprise adherents to the eggs and baskets maxim, however.
These are:
l Very limited diversification yields large reductions in the level of risk. Even spread-
ing the investment funds available into a couple of different securities successfully
eliminates a large amount of risk. Each additional different security added to the
portfolio yields successively less by way of risk reduction.
l Once the portfolio contains about 15 to 20 securities there is little to be gained by
way of risk reduction from further increases in its size. There seems to be some risk
that is impervious to attempts to reduce it through diversification.
That part of the risk that is susceptible to removal by diversification is specific risk;
the stubborn part is systematic risk. Total risk is the sum of these two.
As we saw in the previous chapter, specific (or unsystematic) risk arises from
factors that are random as between one business’s securities and those of another
business. As these factors are random, a reasonably small amount of diversification
will cause them to cancel one another.
The systematic (or portfolio) risk is concerned with economy-wide (macroeco-
nomic) factors that affect all businesses.
The implications of the phenomenon represented in Figure 7.1 are as follows:
l Investors should hold securities in portfolios as, by doing so, risk can be reduced at
little cost.
l There is limited point in diversifying into many more than 15 to 20 different secur-
ities as nearly all the benefits of diversification have been exhausted at that size ofFigure 7.1
The risk of various-
sized, randomly
selected portfolios
As the size of the portfolio is increased, the level of total risk diminishes, but at a decreasing
rate such that, for a portfolio consisting of more than about 15 to 20 securities, adding more
securities does little or nothing to reduce the total risk further. The element of the total risk
that cannot be reduced through diversification is known as systematic risk. The element that
can be removed by diversification is known as specific risk.