Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

V. Risk and Return 13. Return, Risk, and the

Security Market Line

(^456) © The McGraw−Hill
Companies, 2002
typically be a substantial 49 percent per year. If you were to randomly select two stocks
and invest half your money in each, your standard deviation would be about 37 percent
on average, and so on.
The important thing to notice in Table 13.7 is that the standard deviation declines as
the number of securities is increased. By the time we have 100 randomly chosen stocks,
the portfolio’s standard deviation has declined by about 60 percent, from 49 percent to
about 20 percent. With 500 securities, the standard deviation is 19.27 percent, similar to
the 20 percent we saw in our previous chapter for the large common stock portfolio. The
small difference exists because the portfolio securities and time periods examined are
not identical.
The Principle of Diversification
Figure 13.1 illustrates the point we’ve been discussing. What we have plotted is the
standard deviation of return versus the number of stocks in the portfolio. Notice in Fig-
ure 13.1 that the benefit in terms of risk reduction from adding securities drops off as we
add more and more. By the time we have 10 securities, most of the effect is already re-
alized, and by the time we get to 30 or so, there is very little remaining benefit.
Figure 13.1 illustrates two key points. First, some of the riskiness associated with in-
dividual assets can be eliminated by forming portfolios. The process of spreading an in-
vestment across assets (and thereby forming a portfolio) is called diversification.The
428 PART FIVE Risk and Return

FIGURE 13.1

Number of stocks

in portfolio

49.2

Average annual

standard deviation (%)

110

23.9

19.2

Diversifiable risk

Nondiversifiable

risk

20 30 40 1,000

Portfolio Diversification