On economic grounds diversifying and holding a large

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On economic grounds, diversifying and holding a large portfolio eliminates firm-specific risk for two reasons •Each investment is a much smaller percentage of the portfolio, muting the effect (positive or negative) on the overall portfolio. •Firm-specific actions can be either positive or negative. In a large portfolio, it is argued, these effects will average out to zero. (For every firm, where something bad happens, there will be some other firm, where something good happens. Diversification Do not put all your eggs in one basket. Miguel de Cervantes 1642 Put all your eggs in one basket. But watch that basket! Mark Twain.
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11 Diversification Consider standard deviations for individual stocks (1984-1989): Stock Standard Deviation AT&T AT&T 24.2% 24.2% Bristol Myers 19.8% Capital holdings Capital holdings 26.4% 26.4% Digital Equipment 38.4% Exxon Exxon 19.8% 19.8% Ford Motor 28.7% Genentech Genentech 51.8% 51.8% McDonald's 21.7% McGraw Hill McGraw Hill 29.3% 29.3% Tandem Computer 50.7% Equally weighted portfolio Equally weighted portfolio 20.0% 20.0% Example: Diversification Consider a Bank, a Stock Broker and a Collection Agency and their rates of return under the following three states of the economy. All states have equal probability to occur. Example: Diversification State of Economy Boom Normal Recession Expected Return Bank 30% 10% -10% 10% Stock Broker 30% 10% -10% 10% Collection Agency -10% 10% 30% 10%
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