Portfolio Risk
(A client has asked you to explain your suggestion of investing in a portfolio of 10 securities, rather than just one. In your initial post, explain the following:
- The relationship between portfolio risk and the risk of the individual securities in the portfolio
- The relative importance of each security’s risk as the number of securities held in a portfolio increases
- The three primary factors contributing to portfolio risk and which one is the most important
- Answer:
The concept of spreading out various different securities in a stock is called diversification. Diversification is a way to manage risk so that a portfolio’s risk is spread out over a variety and number of different stocks, vs. being beholden to just one. Any one source of risk is done away with. The rationale is that average returns will be greater while reducing individual security risk. Positive performance of many can reduce negative performance of a few. Studies show that portfolios of 25-30 stocks yield the most cost-effective level of risk reduction. Adding a higher number of securities than that can lead to reduced returns of a smaller rate. If one stock is held, risk is higher. The more stocks that are added, the less the risk becomes to a certain point, after which risk is not reduced as more stocks are added. That number has statistically been shown to be around 20-25 stocks. Volatility in standard deviation is greater the closer you get to holding 1 stock, and the closer a portfolio gets to the maximized reduction of volatility and the standard deviation is achieved. Edwin Elton and Martin Gruber wrote a book Modern Portfolio Theory and Investment Analysis where they discovered a single stock portfolio had a risk (standard deviation) of 49% and maximum risk reduction was achieved at a standard deviation of 19% by adding 20 stocks. Adding additional stocks post-20 had very little effect on further standard deviation reduction.
The three primary factors that contribute to portfolio risks are:
The balance between the consequences of being wrong and the probability of being right. This step is the most important as it will affect the other risks down the road. Knowing the risk that is being taken and being fully prepared to take the risk, with backup plans and mitigation techniques in place, should be the main focus and most important step. )
- Choose a number for n between 10 and 30 and explain how many terms would exist in the variance-covariance matrix for this portfolio of n securities. Specify the total number of terms and the number of variances and covariance terms each. Only one student can choose each specific value of n.
- Describe how the risk of this portfolio of n securities would likely compare to the original portfolio of 10 securities.
