(4 marks) Explain why portfolio risk (sp) tends to decrease as the number of stocks in...

Explain why portfolio risk (s_p) tends to decrease as the number of stocks in the portfolio increases.

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Expert Solution

The portfolio risk tends to decrease when the number of stocks go up in a portfolio due to the effects of diversification. The more the number of securities held, the higher the proportion of reducing the risk of unexpected losses due to changes in returns or prices of the stock. It follows a natural rule that not all stocks will reduce in prices at go nor all stocks will increase their prices and hence having a wide variety of stocks balances the overall portfolio risk. Also, when the number of assets grow ,the terms in the formula for variance also grow in an exponential manner which brings down the risk. As well, the weights in each asset and the correlation among the stocks determine the riskiness and a prudent investor will most certainly invest few stocks that have high correlation and few in those that have low correlation which ultimately smoothens the returns of the portfolio over time.

jeff jeffy answered 1 year ago

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