Reduction of Portfolio Risk Through Diversification 📉🛡️
Diversification isn't just about adding stocks; it's about how those stocks cancel out each other's "bad luck." In this chapter, we look at the mechanics of how risk drops as a portfolio grows.
1. The Power of Numbers
When you own only one stock, its specific problems (e.g., a strike at the factory) become your problems. But if you own 50 stocks, a strike at one factory has almost no impact on your total wealth.
As the number of securities in a portfolio increases:
- Unique Risk (Unsystematic Risk) decreases rapidly.
- Market Risk (Systematic Risk) stays constant.
2. The Risk Reduction Graph
If we plot "Number of Stocks" on the X-axis and "Total Portfolio Risk" on the Y-axis, we see a curve that drops sharply at first and then flattens out.
- 1 Stock: 100% Total Risk.
- 10 Stocks: Risk drops significantly (roughly 60-70% reduction).
- 30+ Stocks: Almost all unsystematic risk is gone. Adding more stocks beyond this point (e.g., having 500 stocks) provides very little extra benefit.
Research shows that most of the benefits of diversification are achieved with a portfolio of just 20 to 30 well-chosen stocks from different industries.
3. Limits of Diversification
You can't diversify away everything. No matter how many thousands of stocks you buy, you cannot escape the Systematic Risk.
Total Risk = Diversifiable Risk (Unsystematic) + Non-Diversifiable Risk (Systematic)
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Summary
- More stocks = Less Unsystematic Risk.
- The reduction is very fast for the first 10-20 stocks.
- Total Risk can never go to zero because of Market Risk (inflation, interest rates, war).
- Diversifying beyond 30-40 stocks leads to "over-diversification" where the costs (brokerage) may outweigh the benefits.
Quiz Time! 🎯
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