Lowering Portfolio Risk through

Diversification
Investors have an important choice to make when deciding on the size and
number of investments to hold in their portfolio. On the one hand, investors can
lower the risk of their portfolio through diversification. On the other, transaction
costs increase with the number of stocks purchased.
In this article, we're going to discuss the topic of
portfolio risk and diversification. We're going to Additional Resources
start that discussion with a brief overview of the
Drip Investing
risks contained within a portfolio of stocks.
Next, we'll talk about diversification, and how
Exchange Traded Note
this concept is different from hedging. Finally,
we'll talk about an approach that can be used to
Socially Responsible
minimize risk by using an optimal diversification
Investing
approach.

Portfolio Risk
The Capital Asset Pricing Model tells us there
are two forms of risk to which all portfolios are
exposed:

Dollar Cost Averaging

Low and No Risk

Investments

Understanding Cash
Flow

Systematic Risk: also known

as beta and market risk, this is a macrolevel threat. For example, a recession could depress the performance of
the entire stock market. Systematic risk is evident when a diverse set of
stocks, such as the S&P 500 Index, experience a decline. Hedging is the
only means of mitigating this problem.
Individual Stock Risk: also known as specific, idiosyncratic, and
diversifiable risk, this is security-specific. For example, a company could
make a poor business decision that leads to a lowering of their stock price.
In this scenario, the stock market may continue to rise, but this particular
stock's price would fall. Holding a diversified portfolio of stocks can
mitigate this type of risk.

Diversification versus Hedging

Portfolio risk can be lowered by utilizing two related, but different, techniques.
Systematic risk can be reduced through hedging, while individual stock risk can
be reduced through diversification. The difference between the two concepts is
subtle, but worthwhile reviewing:
Diversification: generally, as the number of assets in a portfolio
increases, the risk of the portfolio decreases. Diversification relies on a
loose relationship between the returns of the assets in the portfolio. For
example, among a group of ten stocks, one company might make a poor
business decision, which results in a decrease in that stock's price.
However, the return on investment for the remaining nine companies were
unaffected by this decision.
Hedging: when two assets are negatively correlated, they can be held
together in a portfolio to reduce systematic risk. For example, during an
economic recession, the prices of stocks will be depressed. Fortunately,
the price of gold typically rises during a recession. This negative
correlation means that gold can be held as a hedge against inflation.
To summarize, the concept of diversification applies to similar assets with
uncorrelated returns. The concept of hedging applies to dissimilar assets with
returns that are negatively correlated.

Creating an Optimized Portfolio

We've talked about how risky it is to hold a single stock, and how that risk is
related to an unexpected event. The example given earlier was a poor business
decision that might hurt profits. The forecasted, or actual, profits for this company
varied from the market's original assumption. Mathematically, we could describe
this risk as variance.
In October 1977, The Journal of Business published Risk Reduction and Portfolio
Size: An Analytical Solution. Written by Edwin J. Elton and Martin J. Gruber, this
study examined the mathematical formulas needed to determine the effect of
diversification on risk. On a more practical level, Elton and Gruber also examined
a portfolio of 3,290 securities, and calculated the variability in returns versus the
number of stocks held in a portfolio.
The table below is based on information appearing in that 1977 publication.

Stocks in Portfolio versus Risk

Stocks

Variance

Risk Reduced

46.811

26.934

24.1%

16.996

39.7%

13.683

45.9%

12.027

49.3%

10

11.033

51.5%

20

9.045

56.0%

50

7.853

59.0%

100

7.455

60.1%

200

7.256

60.6%

500

7.137

61.0%

1000

7.097

61.1%

The above information is interpreted in this manner. The first column of data
shows the number of stocks held in the portfolio. The variance data represents
the actual variance found by Elton and Gruber for each portfolio. The last column
of data demonstrates how much risk is reduced versus holding a portfolio
consisting of a single stock. For example, by holding ten securities in a portfolio
versus a single stock, an investor can lower the variability of their portfolio's return
by 51.5%.
Generally, the conclusion from this study is that diversification beyond 30
securities will not result in a significant reduction in diversifiable risk. From a
practical standpoint, a portfolio consisting of at least 10 stocks will contain less
than half the risk of owning the stock of just one company.

Dollars Invested and Diversification

An investor can lower risk through diversification when they take an existing
investment and spread the dollars over a larger number of stocks. For example,
an investor holding $500,000 in Google stock can mitigate individual stock risk by
selling $450,000 of their Google stock and purchasing $50,000 in the stock of

nine other companies. In this example, the size of the portfolio did not increase, it
remained at $500,000.
If that same investor purchased $50,000 in the stock of nine other companies,
without selling their Google shares, they have increased the total dollars at risk.
Even though they now own shares of stock in ten companies, they now have
$950,000 invested in the market. They didn't decrease the risk associated with
Google stock. Instead, they added additional risk by purchasing shares in nine
other companies too.
This is an important point. By increasing the total money invested in the stock
market, the overall risk of the new portfolio increased. On the other hand,
hedging allows the investor to increase the size of their portfolio (in terms of
dollars), and reduce their overall risk. This occurs because the return of the new
investment increases, when the existing investment declines.