More generally the standard deviation of a portfolio

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Unformatted text preview: correlated. Obviously the prior example is extreme as in the real world it is difficult to find investments that are perfectly negatively correlated and thereby diversify away all risk. More generally the standard deviation of a portfolio is reduced as the number of securities in the portfolio is increased. The reduction in risk will occur if the stock returns within our portfolio are not perfectly positively correlated. The benefit of diversification can be illustrated graphically: Download free ebooks at bookboon.com 29 Corporate Finance Risk, return and opportunity cost of capital Variability in returns (standard deviation %) Figure 2: How portfolio diversification reduces risk Unique risk Total risk Market risk 0 5 10 Number of stocks in portfolio 15 As the number of stocks in the portfolio increases the exposure to risk decreases. However, portfolio diversification cannot eliminate all risk from the portfolio. Thus, total risk can be divided into two types of risk: (1) Unique risk and (2) Market risk. It follows from the graphically illustration that unique risk can be diversified way, whereas market risk is no...
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