Question

Explain the changes observed in the risk of investments when an investor increases the number of stocks in his or her portfolio.

Answer 1

Changes observed in the risk when an investor increases the number of stocks in his/ her portfolio:

Diversification means increasing the number of stocks in a portfolio by adding stocks that have very low/negative/zero coefficient of correlation with each other. Diversification thus spreads risk across stocks belonging to different sectors of the market. Diversification reduces volatility by investing in stocks from different sectors.

If the number of stocks is increased keeping in mind the diversification, there is a chance that the risk of the investment will reduce. Diversification is achieved when we the portfolio consists of stocks belonging to different sectors or if the portfolio replicates the Index. In such a scenario, the diversifiable or firm-specific risk is minimized while the non-diversifiable risk (also known as market risk) remains. Thus through diversification, an investor can reduce the risk of investments by eliminating all or some portion of diversifiable risk. For this purpose stocks that have a low or negative or zero coefficient of correlation among each other are preferred.

Stocks having negative covariance means that they move in opposit direction decreasing the overall risk of the portfolio.