Unformatted text preview: xpected returns. Conversely, an investor who wants higher returns must accept
more risk. The exact trade-off will differ by investor based on individual risk aversion characteristics (i.e.
the individual preference for risk taking). Download free ebooks at bookboon.com
28 Corporate Finance Risk, return and opportunity cost of capital 5.2 The effect of diversification on risk
The risk of an individual asset can be measured by the variance on the returns. The risk of individual
assets can be reduced through diversification. Diversification reduces the variability when the prices of
individual assets are not perfectly correlated. In other words, investors can reduce their exposure to
individual assets by holding a diversified portfolio of assets. As a result, diversification will allow for the
same portfolio return with reduced risk.
- A classical example of the benefit of diversification is to consider the effect of combining the
investment in an ice-cream producer with the investment in a manufacturer of umbrellas. For
simplicity, assume that the return to the...
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