The Effect of Diversification Another Lesson from Market History

In our previous chapter, we saw that the standard deviation of the annual return on a portfolio of 500 large common stocks has historically been about 20 percent per year. Does this mean that the standard deviation of the annual return on a typical stock in that group of 500 is about 20 percent? As you might suspect by now, the answer is no. This is an extremely important observation.

To allow examination of the relationship between portfolio size and portfolio risk, Table 13.7 illustrates typical average annual standard deviations for equally weighted portfolios that contain different numbers of randomly selected NYSE securities.

In Column 2 of Table 13.7, we see that the standard deviation for a "portfolio" of one security is about 49 percent. What this means is that if you randomly selected a single NYSE stock and put all your money into it, your standard deviation of return would

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