234 PART 2 Important Financial Concepts
Nondiversifiable RiskTotal RiskDiversifiable RiskPortfolio Risk,σkP1 5 10 15 20 25
Number of Securities (Assets) in PortfolioFIGURE 5.8Risk Reduction
Portfolio risk and
diversification
- See, for example, W. H. Wagner and S. C. Lau, “The Effect of Diversification on Risk,” Financial Analysts Jour-
nal26 (November–December 1971), pp. 48–53, and Jack Evans and Stephen H. Archer, “Diversification and the
Reduction of Dispersion: An Empirical Analysis,” Journal of Finance23 (December 1968), pp. 761–767. A more
recent study, Gerald D. Newbould and Percy S. Poon, “The Minimum Number of Stocks Needed for Diversifica-
tion,” Financial Practice and Education(Fall 1993), pp. 85–87, shows that because an investor holds but one of a
large number of possible x-security portfolios, it is unlikely that he or she will experience the average outcome. As a
consequence, the study suggests that a minimum of 40 stocks is needed to diversify a portfolio fully. This study tends
to support the widespread popularity of mutual fund investments.
total risk
The combination of a security’s
nondiversifiableand diversifi-
able risk.
diversifiable risk
The portion of an asset’s risk that
is attributable to firm-specific,
random causes; can be elimi-
nated through diversification.
Also called unsystematic risk.
nondiversifiable risk
The relevant portion of an asset’s
risk attributable to market
factors that affect all firms;
cannot be eliminated through
diversification. Also called
systematic risk.
the standard deviation of return, kp, to measure the total portfolio risk, Figure
5.8 depicts the behavior of the total portfolio risk (yaxis) as more securities are
added (xaxis). With the addition of securities, the total portfolio risk declines, as
a result of the effects of diversification, and tends to approach a lower limit.
Research has shown that, on average, most of the risk-reduction benefits of diver-
sification can be gained by forming portfolios containing 15 to 20 randomly
selected securities.^17
The total riskof a security can be viewed as consisting of two parts:Total security riskNondiversifiable riskDiversifiable risk (5.6)Diversifiable risk(sometimes called unsystematic risk) represents the portion of
an asset’s risk that is associated with random causes that can be eliminated
through diversification. It is attributable to firm-specific events, such as strikes,
lawsuits, regulatory actions, and loss of a key account. Nondiversifiable risk(also
called systematic risk) is attributable to market factors that affect all firms; it can-
not be eliminated through diversification. (It is the shareholder-specificmarket
riskdescribed in Table 5.1.) Factors such as war, inflation, international inci-
dents, and political events account for nondiversifiable risk.
Because any investor can create a portfolio of assets that will eliminate virtu-
ally all diversifiable risk, the only relevant risk is nondiversifiable risk.Any
investor or firm therefore must be concerned solely with nondiversifiable risk.
The measurement of nondiversifiable risk is thus of primary importance in select-
ing assets with the most desired risk–return characteristics.