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# diversification will normally reduce the riskiness of a portfolio of stocks.

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## Big Time 1.1 Flashcards

Start studying Big Time 1.1. Learn vocabulary, terms, and more with flashcards, games, and other study tools.

## Big Time 1.1

False

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The tighter the probability distribution of its expected future returns, the greater the risk of a given investment as

measured by its standard deviation

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True

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The coefficient of variation, calculated as the standard deviation of expected returns divided by the expected return, is a

standardized measure of the risk per unit of expected return.

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### Textbook solutions for this set

Principles of Economics

8th Edition N. Gregory Mankiw 814 explanations

4th Edition

Karen Borrington, Peter Stimpson

467 explanations

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### Terms in this set (217)

False

The tighter the probability distribution of its expected future returns, the greater the risk of a given investment as

measured by its standard deviation

True

The coefficient of variation, calculated as the standard deviation of expected returns divided by the expected return, is a

standardized measure of the risk per unit of expected return.

False

The standard deviation is a better measure of risk than the coefficient of variation if the expected returns of the

securities being compared differ significantly

True

Risk-averse investors require higher rates of return on investments whose returns are highly uncertain, and most

investors are risk averse

True

When adding a randomly chosen new stock to an existing portfolio, the higher (or more positive) the degree of

correlation between the new stock and stocks already in the portfolio, the less the additional stock will reduce the

portfolio's risk. True

Diversification will normally reduce the riskiness of a portfolio of stocks.

True

In portfolio analysis, we often use ex post (historical) returns and standard deviations, despite the fact that we are really

interested in ex ante (future) data

False

The realized return on a stock portfolio is the weighted average of the expected returns on the stocks in the portfolio.

True

Market risk refers to the tendency of a stock to move with the general stock market. A stock with above-average market

risk will tend to be more volatile than an average stock, and its beta will be greater than 1.0.

False

An individual stock's diversifiable risk, which is measured by its beta, can be lowered by adding more stocks to the

portfolio in which the stock is held.

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### Related questions

QUESTION

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## The Importance Of Diversification

Diversification in investing is a technique that reduces risk by allocating investments among various financial instruments. Learn how to maximize returns without increasing substantial risk in your portfolio.

## What Is Diversification in Investing?

Diversification is a technique that reduces risk by allocating investments across various financial instruments, industries, and other categories. It aims to maximize returns by investing in different areas that would each react differently to the same event.

Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk. Here, we look at why this is true and how to accomplish diversification in your portfolio.

### KEY TAKEAWAYS

Diversification reduces risk by investing in vehicles that span different financial instruments, industries, and other categories.

Unsystematic risk can be mitigated through diversification while systemic or market risk is generally unavoidable.

Balancing a diversified portfolio may be complicated and expensive, and it may come with lower rewards because the risk is mitigated.

## Understanding Diversification in Investing

Let's say you have a portfolio that only has airline stocks. Share prices will drop following any bad news, such as an indefinite pilot strike that will ultimately cancel flights. This means your portfolio will experience a noticeable drop in value.

You can counterbalance these stocks with a few railway stocks, so only part of your portfolio will be affected. In fact, there is a very good chance that these stock prices will rise, as passengers look for alternative modes of transportation.

You could diversify even further because of the risks associated with these companies. That's because anything that affects travel will hurt both industries. Statisticians may say that rail and air stocks have a strong correlation. This means you should diversify across the board—different industries as well as different types of companies. The more uncorrelated your stocks are, the better.

By diversifying, you're making sure you don't put all your eggs in one basket.

Be sure to diversify among different asset classes, too. Different assets such as bonds and stocks don't react the same way to adverse events. A combination of asset classes like stocks and bonds will reduce your portfolio's sensitivity to market swings because they move in opposite directions. So if you diversify, unpleasant movements in one will be offset by positive results in another.

And don't forget location, location, location. Look for opportunities beyond your own geographical borders. After all, volatility in the United States may not affect stocks and bonds in Europe, so investing in that part of the world may minimize and offset the risks of investing at home.

## How Many Stocks You Should Have

Obviously, owning five stocks is better than owning one, but there comes a point when adding more stocks to your portfolio ceases to make a difference. There is a debate over how many stocks are needed to reduce risk while maintaining a high return. The most conventional view argues that an investor can achieve optimal diversification with only 15 to 20 stocks spread across various industries.

## Different Types of Risk

Investors confront two main types of risk when they invest. The first is known as systematic or market risk. This type of risk is associated with every company. Common causes include inflation rates, exchange rates, political instability, war, and interest rates. This category of risk is not specific to any company or industry, and it cannot be eliminated or reduced through diversification. It is a form of risk that all investors must accept.

Systematic risk affects the market in its entirety, not just one particular investment vehicle or industry.

The second type of risk is diversifiable or unsystematic. This risk is specific to a company, industry, market, economy, or country. The most common sources of unsystematic risk are business risk and financial risk. Because it is diversifiable, investors can reduce their exposure through diversification. Thus, the aim is to invest in various assets so they will not all be affected the same way by market events.

## Problems with Diversification

Professionals are always touting the importance of diversification but there are some downsides to this strategy. First, it may be somewhat cumbersome managing a diverse portfolio, especially if you have multiple holdings and investments.

Diversification can also be expensive. Not all investment vehicles cost the same, so buying and selling will affect your bottom line—from transaction fees to brokerage charges. And since higher risk comes with higher rewards, you may end up limiting your returns.

Next, consider how complicated it can be. For instance, many synthetic investment products have been created to accommodate investors' risk tolerance levels. These products are often complex and aren't meant for beginners or small investors. Those with limited investment experience and financial backing should consider purchasing bonds to diversify against stock market risk.

Unfortunately, even the best analysis of a company and its financial statements cannot guarantee it won't be a losing investment. Diversification won't prevent a loss, but it can reduce the impact of fraud and bad information on your portfolio.

## What Does Diversification Mean in Investing?

Diversification is a strategy that aims to mitigate risk and maximize returns by allocating investment funds across different vehicles, industries, companies, and other categories.

Source : www.investopedia.com

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