2 – L3 02 Diversification V3

Since you’ve studied the stocks in your universe now for a while, you might already know which stock has been performing the best. Let’s call it New Digital Corporation. At this point, you may want to put all your money in New Digital stock. But let’s say you do this and New Digital stock keeps increasing in value for a while, but suddenly drops to half the price you purchased that. Since you used all your money to buy the stock, you just lost half your money. Ouch! What if instead you put half your money in New Digital and half your money in Big Pharma Company? Intuitively, this seems like it could smooth out the dips and value of your investment, because New Digital could start doing well when it launches a new tech product, while Big Pharma recovers from a failed drug trial. Big pharma might start doing well when it’s research arm, deliver several new promising candidate drugs, while New Digital struggles during a change in management. What we’ve done here is reduced our portfolio risk by diversifying our portfolio. But why not keep spreading our money into more and more stocks? Can we reduce our portfolio risk indefinitely? If all the sources of risk are independent, we could in theory, reduce risk to zero by spreading our money between more and more stocks. This would be the case if each company is only subject to its own independent sources of risk, and there are no risks common to all companies. Risks specific to individual companies is called idiosyncratic risk or specific risk. However, in the real world, all companies are subject to common sources of risk that affect the entire economy such as the risks of inflation, recession, or change in interest rates or GDP. Risk attributable to market-wide sources is called market risk or systematic risk. Let’s see if we can quantify this risk and find some guidelines for how to allocate our money.

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