Total risk consists of systematic risk and unsystematic risk. Unsystematic risk can be eliminated by diversification. One study showed that it only took about 12 to 18 stocks in a portfolio to achieve 90% of the maximum diversifictaion possible. Another study indicated it took 30 securities.Whatever the number, it is significantly less than all securities.
Consider a biotech stock with one new drug product. If it turns out that this drug is very effective, the stock returns will be quite hite. But if it turns out that it is not safe, then the stock returns will be low. But these are all from firm-specific factors. These unsystem risk can be eliminated by diversification. Since market factors such as economic growth rate have little to do with the outcome for this stock, systematic risk is a small proportion of the total risk of the stock.
Now consider an established manufacturer of machine tools. The stock of this company may have a greater sensitivity to market risjk factor than biotech stock.
The stock with more total risk has less systematic risk and will therefore have a lower equilibrium rate of return according to capital market theory. Unsystematic risk is not compensated in equilibrium because it can be eliminated for free through diversification. Systematic risk is measured by the contribution of a security to the risk of a well doversiffied portfolio and the expected equilibrium return (required return) on an individual security will repend on its systematic risk.
Now, one question came up in my mind -
Why not everyone do the diversification? For example, Warren Buffett does not use diversification method. Why?
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