Number of stocks in portfolio

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

V. Risk and Return

13. Return, Risk, and the Security Market Line

© The McGraw-Hill Companies, 2002

CHAPTER 13 Return, Risk, and the Security Market Line principle of diversification tells us that spreading an investment across many assets will eliminate some of the risk. The blue shaded area in Figure 13.1, labeled "diversifi-able risk," is the part that can be eliminated by diversification.

The second point is equally important. There is a minimum level of risk that cannot be eliminated simply by diversifying. This minimum level is labeled "nondiversifiable risk" in Figure 13.1. Taken together, these two points are another important lesson from capital market history: diversification reduces risk, but only up to a point. Put another way, some risk is diversifiable and some is not.

To give a recent example of the impact of diversification, the Dow Jones Industrial Average (DJIA), which is comprised of 30 large, well-known U.S. stocks, was down about 6 percent in 2000. As we saw in our previous chapter, this represents a moderately bad year for a portfolio of large-cap stocks. The biggest individual losers for the year were AT&T (down 66 percent), Hewlett-Packard (down 44 percent), and Microsoft (down 63 percent). Working to offset these losses were Boeing (up 61 percent) and Philip Morris (up a "smoking" 100 percent). Again, the lesson is clear: Diversification reduces exposure to extreme outcomes, both good and bad.

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