The Principle of Diversification

Figure 13.1 illustrates the point we've been discussing. What we have plotted is the standard deviation of return versus the number of stocks in the portfolio. Notice in Figure 13.1 that the benefit in terms of risk reduction from adding securities drops off as we add more and more. By the time we have 10 securities, most of the effect is already realized, and by the time we get to 30 or so, there is very little remaining benefit.

Figure 13.1 illustrates two key points. First, some of the riskiness associated with individual assets can be eliminated by forming portfolios. The process of spreading an investment across assets (and thereby forming a portfolio) is called diversification. The

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