bre44380_ch07_162-191.indd 175 09/02/15 04:11 PM
Chapter 7 Introduction to Risk and Return 175two-stock portfolios, five-stock portfolios, etc. You can see from Figure 7.9 that diversifica-
tion can cut the variability of returns about in half. Notice also that you can get most of this
benefit with relatively few stocks: The improvement is much smaller when the number of
securities is increased beyond, say, 20 or 30.
Diversification works because prices of different stocks do not move exactly together. Stat-
isticians make the same point when they say that stock price changes are less than perfectly
correlated. Look, for example, at Figure 7.10, which plots the prices of Ford and Newmont
Mining for the 60 months ending October 2014. As we showed in Table 7.3, during this period
the standard deviation of returns was about 30% for Newmont and 31% for Ford. Although the
two stocks enjoyed a fairly bumpy ride, they did not move in exact lockstep. Often a decline in◗ FIGURE 7.9
Average risk (stan-
dard deviation) of
portfolios containing
different numbers of
stocks. The stocks
were selected ran-
domly from stocks
traded on the New
York Exchange from
2006 through 2010.
Notice that diversi-
fication reduces risk
rapidly at first, then
more slowly.
Note: The figure shows the
average risk of randomly
selected portfolios divided
equally among N stocks. The
group of stocks consists of all
those continuously quoted on
the NYSE, 2006–2010.Number of stocksStandard deviation, %051015202530354045501357911131517 19 21 23 25 27 29◗ FIGURE 7.10
The value of a port-
folio evenly divided
between Newmont
Mining and Ford was
less volatile than
either stock on its
own. The assumed
initial investment is
$100.Newmont
Ford
50–50 PortfolioDollars05010015020025011/2/20095/2/201011/2/20105/2/201111/2/20115/2/201211/2/20125/2/201311/2/20135/2/201411/2/2014BEYOND THE PAGEmhhe.com/brealey12eTry It! Risk
and increasing
diversification