Question

In Chapter 11 we discussed diversifiable vs. non-diversifiable (i.e., "Systematic") risk.

A diversified portfolio reduces non-systematic (i.e., "diversifiable") risk.

But, what if I do not diversify, and therefore hold some portion of diversifiable risk that I have not reduced through diversification? I am taking more risk, and I need more return to compensate me for the additional risk.

But, will the marketplace compensate me for the additional risk I am taking? Will assets be priced such that I can comfortably take the additional risk and get paid for it?

Answer 1

Solution:-

When it comes to any individual security, the price of that security is arrived by the market after discounting thr risk of that security. So, whatever non-systematic or systematic risk a security is exposed to, the market takes that into consideration and the price of the security is arrived thereafter.

Thus, when an investor any particular security, he pays a price after discounting all the risks of that security- systematic or non-systematic. Does this mean that if an investor invests his portfolio without diversification, he will have to pay a lesser price for the securities than what he would pay if he buys multiple diverse securities for the portfolio? No. The purchase price of a certain stock (whether its 100% of portfolio or 2%) will be the same, however in case of a well diversified portfolio, the exposure to one stock becomes smaller, such that any impact on a certain company or an industry doesn't have a huge impact to the whole portfolio. Similarly, a high return on a stock or industry doesn't result in huge gains for portfolio either.

In either words, the price of assets don't change whether they are acquired alone or as part of a diversified portfolio. However, the risk and returns from a certain asset does get smaller in a diversified portfolio simply because it holds a small share in the portfolio.

Thus, to conclude a diversifed portfolio reduces NOT the absolute risk from a particular stock but it reduces relative risk to the portfolio from one asset considering its small share in the overall portfolio. An investor who buys just one asset rather than a diversified portfolio can make higher returns and are exposed to higher risks because just few events related to that stock or industry can make a big positive or negative difference considering one stock is the whole portfolio as compared to the impact the same events would have had the stock been just a small part of a large diversified portfolio.