The concept of diversification makes such common sense that our language even contains everyday expressions that exhort us to diversity (“Don’t put all your eggs in the one basket.�) The idea is to spread your risk across a number of assets or investments. While pointing us in the right direction, this is a rather naïve approach to diversification. It would seem to imply that investing $10,000 evenly across ten different securities makes you more diversified than the same amount of money invested evenly across 5 securities. The catch is that naïve diversification ignores the covariance (or correlation) between security returns. The portfolio containing 10 securities could represent stocks from only one industry and have returns that are highly correlated. The 5-stock portfolio might represent various industries whose security returns might show low correlation and, hence, low portfolio return variability.

Meaningful diversification, combining securities in a way that will reduce risk say in the case of security A. Here the returns over time for security A are cyclical in that they move with the economy in general. If we say returns for security B are mildly countercyclical mean the returns for these two securities are negatively correlated. Equal amount invested in both securities will reduce the dispersion of return, on the portfolio of investments. This is because some of each individual security’s variability is offsetting. Benefits of diversification, in the form of risk reduction, occur as long as securities are not perfectly, positively correlated.

Investing in World financial markets can achieve greater diversification than investing in securities from a single country. The economic cycles of different countries are not completely synchronized, and a weak economy in one country may be offset by a strong economy in another. Moreover, exchange-rate risk other risk add to the diversification effect.

Systematic and Unsystematic Risk:

We have stated that combining securities that are not perfectly, positively correlated helps to lessen the risk of a portfolio. How much risk reduction is reasonable to expect, and how many different security holdings in a portfolio would be required?

Researchers studies have looked at what happens to portfolio risk an randomly selected stocks are combined to form equally weighted portfolios. When we begin with a single stock, the risk of the portfolio is the standard deviation of that one stock. As the number of randomly selected stocks held in the portfolio is increased, the total risk of the portfolio is reduced. Such a reduction is at a decreasing rate. Thus, a substantial proportion of the portfolio risk can be eliminated with a relatively moderate amount of diversification, say, 15 to 20 randomly selected stocks in equal-dollar amounts.

Total Risk = (non-diversifiable or unavoidable | Systematic risk) + (diversifiable or avoidable | Unsystematic risk)

Systematic Risk:

The variability of return on stocks or portfolios associated with changes in return on the market as a whole.

Unsystematic Risk:

The variability of return on stocks or portfolios not explained by general market movements. It is avoidable through diversification.

The first part, systematic risk, is due to risk factors that affect the overall market—such changes in the nation’s economy, tax reform by Congress, or a change in the world energy situation. These are risks that affect securities overall and, consequently, cannot be diversified away. In other words, even an investor who holds a well-diversified portfolio will be exposed to this type of risk.

The second risk component, unsystematic risk, is risk unique to a particular company or industry; it is independent of economic, political, and other factors that affect all securities in a systematic manner. A wild cat strike may affect only one company; a new competitor may begin to produce essentially the same product; or a technological breakthrough can make an existing product obsolete. For most stocks unsystematic risk accounts for around 50 percent of the stock’s total risk or standard deviation However, by diversification this kind of risk can be reduced and even eliminated if diversification is efficient.

Therefore, not all of the risk involved in holding a stock is relevant because part of this risk can be diversified away. The important risk of a stock is its unavoidable or systematic risk. Investors can expect to be compensated for bearing this systematic risk. They should not, however, expect the market to provide any extra compensation for bearing avoidable risk. It is this logic that lies behind the capital-asset pricing model.