Question

(e) Briefly outline why investors who fail to diversify their holdings should not be compensated for the additional risk they face.

Answer 1

Diversification is the only free investment lunch because an individual may reduce risk, if properly done, without growing their expected return. And amid this knowledge, many people hold concentrated positions in one stock when they can easily diversify the idiosyncratic, single-company danger

It's important to distinguish between two different types of risk when investing: good risk and bad risk. Good risk is the type that you are offset to take. Investors are compensated for taking systematic or undiversifiable risks. The compensation comes in the form of higher expected returns (not guaranteed returns, or risk would not be present). Bad risk is the type no compensation exists for. So, it's called risk uncompensated, or unsystematic.

Equity investors face multiple types of risk that are true of any risky asset, whether it is a stock or bond. Firstly, there is the peculiar risk of investing in stocks. No matter how many stocks, sector funds, or different asset classes you own, that risk can not be diversified away. That is why the market offers a risk premium for equity.

Since the risk of ownership of a single stock can be diversified away, the market does not compensate investors for assuming this type of (unsystematic) risk. And because the danger can be diversified away without reducing expected returns, it remains a mystery why so many creditors keep concentrated portfolios.