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Portfolio Risk Management, Systematic Risk and Unsystematic Risk

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Suppose an individual investor starts with a portfolio that consists of one randomly selected stock.

a. What will happen to the portfolio's risk if more and more randomly selected stocks are added?
b. What are the implications for investors? Do portfolio effects have an impact on the way investors should think about the riskiness of individual securities.
c. Explain the differences between stand-alone risk, diversifiable risk, and portfolio risk.
d. Suppose that you choose to hold a single stock investment in isolation. Should you expect to be compensated for all of the risk that you assume?

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Solution Preview

a) The standard deviation gets smaller as more stocks are combined in the portfolio while Rp (portfolio's return) remains constant. Thus, by adding stocks to your portfolio, which initially started as a 1-stock portfolio, risk has been reduced. Stocks are generally positively correlated because they are all affected by the general economic environment. (e.g. if the economy grows, stocks performance should be good as well).
When additional stocks are included in the portfolio, the portfolio's standard deviation decreases because added stocks are not perfectly positively correlated. (Figure 1)
Be that as it may, as more and more stocks are added, each new stock has less of an impact ...

Solution Summary

The solution provides an explanation of Systematic Risk and Unsystematic Risk by comparing a 1-stock portfolio and diversified portfolio.

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