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 largeportfolio, 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. DiversificationDo not put all your eggs in one basket.Miguel de Cervantes 1642Put all your eggs in one basket. But watch that basket!Mark Twain.
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11Diversification•Consider standard deviations for individual stocks (1984-1989):StockStandard DeviationAT&TAT&T24.2%24.2%Bristol Myers19.8%Capital holdingsCapital holdings26.4%26.4%Digital Equipment38.4%ExxonExxon19.8%19.8%Ford Motor28.7%GenentechGenentech51.8%51.8%McDonald's21.7%McGraw HillMcGraw Hill29.3%29.3%Tandem Computer50.7%Equally weighted portfolio Equally weighted portfolio 20.0%20.0%Example: DiversificationConsider 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: DiversificationState of Economy Boom Normal Recession Expected Return Bank 30% 10% -10% 10% Stock Broker 30% 10% -10% 10% Collection Agency -10% 10% 30% 10%