The risk reduction is quite dramatic. We find that two thirds of an investment’s total risk can be diversified away, while the remaining one third of risk cannot be diversified away. A well-diversified portfolio is very easy to obtain, all we have to do is buy a portion of a larger fund that is already well-diversified, like buying into a unit trust or a tracker fund.
Remember that the real joy of diversification is the reduction of risk without any consequential reduction in return. If we assume that investors are rational and risk averse, their portfolios should be well-diversified, ie only suffer the type of risk that they cannot diversify away (systematic risk).
An investor who has a well-diversified portfolio only requires compensation for the risk suffered by their portfolio (systematic risk). Therefore we need to re-define our understanding of the required return:
Required return = Risk free return + Systematic risk premium
Investors who have well-diversified portfolios dominate the market. They only require a return for systematic risk. Thus we can now appreciate the statement ‘that the market only gives a return for systematic risk’.
The next question will be how do we measure an investment’s systematic risk? The answer to this question will be given in the following article on the Capital Asset Pricing Model (CAPM).
10 KEY POINTS TO REMEMBER
1. The expected return on a share consists of a dividend yield and a capital gain/loss in percentage terms.
2. The required return on a risky investment consists of the risk-free rate (which includes inflation) and a risk premium.
3. Total risk is normally measured by the standard deviation of returns ( σ ).
4. Portfolio theory demonstrates that it is possible to reduce risk without having a consequential reduction in return, ie the portfolio’s expected return is equal to the weighted average of the expected returns on the individual investments, while the portfolio risk is normally less than the weighted average of the risk of the individual investments.
5. The extent of the risk reduction is influenced by the way the returns on the investments co-vary. Covariability is normally measured in the exams by the correlation coefficient.
6. In reality, the correlation coefficient between returns on investments tend to lie between 0 and +1. Thus total risk can only be partially reduced, not eliminated.