We have stated that combining securities that are not perfectly, positively correlated helps to lessen the risk of a portfolio. How much risk reduction is reasonable to expect, and how many different security holdings in a portfolio would be required?
Research studies have looked at what happens to portfolio risk as randomly selected stocks are combined to form equally weighted portfolios. When we begin with a single stock, the risk of the portfolio is the standard deviation of that one stock. As the number of randomly selected stocks held in the portfolio is increased, the total risk of the portfolio is reduced. Such a reduction is at a decreasing rate, however. Thus a substantial proportion of the portfolio risk can be eliminated with a relatively moderate amount of diversification -say, 20 to 25 randomly selected stocks in equal-dollar amounts. Conceptually, this is illustrated.
As the figure shows, total portfolio risk comprises two components: Systematic risk Unsystematic risk Total risk = (nondiversifiable + (diversifiable or unavoidable) or avoidable) The first part, systematic risk, is due to risk factors that affect the overall market - such as changes in the nation's economy, tax reform by Congress, or a change in the world energy situation. These are risks that affect securities overall and, consequently, cannot be diversified away. In other words, even an investor who holds a well-diversified portfolio will be exposed to this type of risk.
The second risk component, unsystematic risk, is risk unique to a particular company or industry; it is independent of economic, political, and other factors that affect all securities in a systematic manner. A wildcat strike may affect only one company; a new competitor may begin to produce essentially the same product; or a technological breakthrough may make an existing product obsolete. For most stocks, unsystematic risk accounts for around 50 percent of the stock's total risk or standard deviation. However, by diversification this kind of risk