DIVERSIFICATION AND PORTFOLIO RISK

Diversification means reducing risk by investing in a variety of assets. In other words, you are spreading risks among assets. There are two different types of risk in investment.

1. Market risk
-Systematic or Nondiversifiable
2. Firm-specific risk
-Diversifiable or nonsystematic

Market risk is systematic and everyone involved in market must bear it. On the other hand, firm specific can be diversified to some degree.

Here's a figure showing Portfolio Risk as a Function of the Number of Stocks.

As you can see on the B, market risk is fixed at some level and firm-specific adds up.

Portfolio Risk as a Function of Number of Securities

A graph above illustrates that risk (std deviation) declines as the number of stocks in a portfolio increases.