“Diversification and Portfolio Risk “
Ali wants to invest in the stock market while making its total risk zero by creating a unique portfolio. In this mode, he starts from choosing a single stock and adding multiple stocks to this one in order to develop a series of portfolios of his choice. Number of securities range from 1 to 1,000 in the different designed portfolios but he remains unable to get his desired risk level. Despite of rigorous computations, the risk level is still away from zero.
Can the total risk of portfolio be reduced exactly to zero? Why or why not? Discuss with conceptual rationale.
Each investment has two types of risk associated with it.
1- Business risk also called Unsystematic risk and… A risk that is company specific.
2- Market Risk also known as Systematic risk… A risk over which company has no control.
The only risk that can be reduced to 0 is Business risk by means of diversification. The concept of diversification means, the investor invests his capital in different projects having different level of risk instead of putting all the eggs in same basket. If the performance of one of his investment go down due to any company specific reasons, like strikes by the labour force, inefficient management etc. The performance of other investment go up… and hence compensating it with those and risk is minimised.
Market risk is a risk which affects the overall market and over which nobody has control. It affects a large number of assets. this is a risk that comes into play because of for example GDP of the economy, changes is inflation and interest rates result of which cause change in cost of material, Wages, and the assets business owned. so this type of risk cannot be minimized by means of diversification. This risk is almost always there in investment portfolio.
Hence, I am concluding to the point that, Mr. Ali’s portfolio risk can’t be reduced to zero. It can however be reduced to zero in context of unsystematic risk but not in full. For Diversification to play its role effectively Mr.Ali should keep in mind that the projects are not perfectly correlated to each other.
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