Why is the portfolio approach an effective tool to manage risk? Explain your answer.
(Not everyone believes in the portfolio approach, and there is also the fundamental analysis idea, which is completely contrary to the portfolio approach. Most people in the industry believe the fundamental approach. Theorists believe in the portfolio approach).
Assuming that we believe in the portfolio approach, and that all the conditions are met, it is an effective way to manage risk.
The modern portfolio theory (MPT) believes that stocks should not be selected on an individual basis. Rather, one should consider how stocks behave as a whole (i.e. covariance among stocks) and select them as a group to maximize return.
In finance, risk is define as the standard deviation of expected return. Consider ...