Question

Can you explain why diversification can reduce risk on a portfolio of securities? Provide an example.

Answer 1

Risk is of two Types. They are

i) Systematic Risk - Which is common to all in the industry and can't be diversified through diversification.

ii) Un Systematic Risk - It is Organization specific and can be reduced to Zero, If r is "-1".

Ex:

Particulars	Amount
Weight in A	0.5
Weight In B	0.5
SD of A	12%
SD of B	12%
r	-1

Portfolio SD :

Portfolio SD = SQRT[((Wa*SDa)^2)+((Wb*SDb)^2)+2*(wa*SDa)*(Wb*SDb)*r(1,2)]

=SQRT[((0.5*0.12)^2)+((0.5*0.12)^2)+2*(0.5*0.12)*(0.5*0.12)*-1]

=SQRT[((0.06)^2)+((0.06)^2)+2*(0.06)*(0.06)*-1]

=SQRT[0]

0.00%

Pls commrnt, if any further assistance is required.