Question

why isn't the total risk of a portfolio simply equal to the weighted average of the risks of the securities in the portfolio

Answer 1

Portfolio consists of various securities and also risk related to those securities. While we calculate the return of portfolio, we take weighted average of returns of portfolio. As returns don't contain any diversification , it is easy to calculate return of portfolio by averaging returns of all the securities in the portfolio. In case of risk management in portfolio, investors manages to diversify risks so that investor gets higher returns but by taking lower amount of risks. Investors always thinks to diversify it's risks in the portfolio by getting higher returns and lower risks. But all the risks cannot be diversified as portfolio of risks contains systematic risk and unsystematic risks. Systematic risks cannot be managed easily by investors. It cannot be diversified.

Diversification of risks is managing investment in portfolio by managing the risks i.e. which security is giving higher return and less risk, which security is giving highest return but with more risk so that investor can think about where to invest more and where to invest less. Diversification is arranging the investment in securities by reducing the risk of portfolio. So investor has to think about this diversification process as everything depends on this diversification of securities. Systematic risk of portfolio doesn't affect by diversification as this risk is market related risks. Systematic risks i.e. market related risk cannot be removed because everyday variations happens in the market and this is not in investors hand to eliminate those kind of risks. Whereas unsystematic risks are firm related risks and can be affected by diversification. This risks are in the hands to investors as it is only related to firm and not to the whole market. Systematic risks is related to whole market and fluctuations, variations , changes happens in the market all the time which investor cannot do anything about it.

It also depends on the factor correlation coefficient. Correlation coefficient shows how two securities of portfolio affecting each other. Not only individual assets but pair of individual assets also has to be seen while calculating risk of portfolio. Correlation coefficient means how securities of portfolio affect in relation to each other. Portfolio has two variables i.e. zero correlation coefficient and between -1 and +1 correlation coefficient. Zero correlation means two securities are acting independently of each other. It is possible to weighted average risks of portfolio when correlation coefficient is +1 which is rare. Therefore, the total risk of portfolio isn't simply equal to weighted average of risks of portfolio as investors cannot completely eliminate systematic risk of portfolio causing it to not being equal to weighted average of risks of portfolio.