Question

(1) Should portfolio effects influence how investors think about the risk of individual stocks? (2) If you decided to hold a one-stock portfolio and consequently were exposed to more risk than diversified investors, could you expect to be compensated for all of your risk; that is, could you earn a risk premium on that part of your risk that you could have eliminated by diversifying?

Answer 1

A. Yes, portfolio effect are influencing how investors are thinking about risk of individual stock because if the stock is not present in a Portfolio, it will mean that the risk of individual stocks are going higher but if it is a part of portfolio then there will be benefit related to diversification and there will be elimination of unsystematic risk associated with Portfolio Management and it will mean that the overall risk is eliminated to some extent and Portfolio is providing a lower risk assigned to individual security due to presence of diversification

2. YES, there will be a risk premium associated with non diversifying my portfolio because there will be an element of making a very high rate of return because I will have excess risk as I will not be diversifying my portfolio.

when I will not be diversifying my portfolio, then I will be completely exposed to the movement of one particular asset and I will have excess chance of making high rate of return because there will be no diversification.

But if we are constantly looking through Capital Asset pricing model, then it it already determined that all portfolio should be diversified and it always assign systematic risk and risk premium accordingly and hence it does not offer with additional risk premium for non diversification.