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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
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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- Spring '12