Suppose an individual investor starts with a portfolio that consists of one rand

Question

Suppose an individual investor starts with a portfolio that consists of one randomly selected stock.

a. What will happen to the portfolio’s risk if more and more randomly selected stocks are added?

b. What are the implications for investors? Do portfolio effects have an impact on the way investors should think about the riskiness of individual securities?

c. Explain the differences between stand-alone risk, diversifiable risk, and portfolio risk.

d. Suppose that you choose to hold a single stock investment in isolation. Should you expect to be compensated for all of the risk that you assume?

Explanation / Answer

If more and more randomly selected stocks are added in the portfolio the overall risk will reduced but expected return would remain constant. As additional stocks are added in the portfolio are not perfectly positivly correlated ,Hence it reduced the standard deviation of the portfolio.Thus, individual should hold well diversified portfolio of stocks rather then individual stocks for reducing overall risk of the portfolio.

b.Yes, Portfolio effects have an impact on the way investors should think about the riskiness of individual securities.A stock's stand alone risk is more important to undiversified investor measured by standard deviation but its unrelavant to the diversified portfolio investor because he is more concern about the market risk, as it would be present how well your divesified portfolio is,It can't be neglected.

b.

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