Question

Explain why risk is reduced for a portfolio of many stocks. How does diversification work in practice?

Answer 1

There are two types of risk 1) systematic risk and 2) unsystematic risk

1) Systematic risk is also known as market risk. it can not be avoided by diversification . For example if there is depression in economy than all the stock belonging to different sectors will be affected

2) unsystematic risk refers to stock specific risk, it can be reduced through diversification. For example if one has portfolio consist of all IT stocks than any bad news about IT industry will affect the whole portfolio as against this if portfolio consist of it stocks, Auto stocks, Banking stocks etc bad news of IT sector will be covered by good news in any other sector plus exposure alone in IT stock is also reduced. Thus diversification helps to reduce risk