Question

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

Answer 1

The portfolio risk tends to reduce as the number of securities in a portfolio increases because the as the number of securities in a portfolio increases and if the correlation between the movement of returns of those securities is low then the overall return of the portfolio stabilizes. This is because when the correlation is negative if one stock did not do well then, the other stock did well and the overall return of the portfolio is not significantly negatively affected. This is also known as the diversification. As more securities are added to the portfolio the overall risk of the portfolio reduces then the individual risk of the securities. When we calculate the standard deviation of the portfolio then we not just consider their weight of the portfolio and risk of the individual securities, we do also consider the correlation between the returns of those securities and if the correlation of the returns of securities are negative then the overall risk of the portfolio reduces. It is because having a large number of stocks in the portfolio reduces the volatility of the overall return of the portfolio.