(^64) Financial Management
bonds, real estate, savings accounts and various other assets. In other words, the investor
does not put all his eggs into one basket.
Diversifiable and Non-diversifiable Risk
The fact that returns on stocks do not move in perfect tandem means that risk can be
reduced by diversification. But the fact that there is some positive correlation means
that in practice risk can never be reduced to zero. So there is a limit on the amount of
risk that can be reduced through diversification. The lower the degree of positive
correlation, the greater is the amount of risk reduction that is possible.
The amount of risk reduction achieved by diversification also depends on the number of
stocks in the portfolio. As the number of stocks in the portfolio increases, the diversifying
effect of each additional stock diminishes.
As you can see that the major benefits of diversification are obtained with the first 10
to 12 stocks, provided they are drawn from industries that are not closely related.
Increases beyond this point continue to reduce the total risk but the benefits are marginal.
It is also apparent that it is the diversifiable risk that is being reduced unlike the non-
diversifiable risk which remains constant whatever your portfolio is.
frankie
(Frankie)
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