A well-diversified portfolio is a portfolio that includes a large enough number of _____ securities to make the _____ risk negligible.

Question

BlackTom AI · Accepted Answer

Diversification reduces the impact of firm-specific shocks by combining many different securities so that idiosyncratic outcomes cancel out.

1. Relevant knowledge points and concepts
- Two types of risk: systematic (market) risk affects all assets (e.g., recessions, interest-rate changes) and cannot be eliminated by diversification; nonsystematic (idiosyncratic or firm-specific) risk affects individual securities (e.g., management errors, lawsuits) and can be reduced by holding a portfolio of many assets. 
- A well-diversified portfolio aims to make nonsystematic risk negligible by including enough securities whose returns are not perfectly correlated.

2. Step-by-step reasoning
- If you hold only one or a few similar securities, firm-specific events will materially change portfolio value because their idiosyncratic risks are concentrated.
- Adding additional securities with different, uncorrelated (or less correlated) idiosyncratic risk causes positive and negative firm-specific returns to offset each other.
- As the number of different securities increases, the portfolio’s aggregate nonsystematic variance declines toward zero; however, systematic variance remains.

3. Intermediate conceptual “calculation” steps
- Portfolio variance = systematic variance + nonsystematic variance/n (roughly). As n (number of different securities) increases, the nonsystematic component divided by n approaches zero.
- Empirically, a diversified portfolio of 20–30 different stocks captures most diversification benefits; beyond that, further reduction is marginal.

4. Why the correct answer is correct
- The phrase “different; nonsystematic” correctly states that a portfolio needs a large enough number of different securities to make nonsystematic (firm-specific) risk negligible. Different securities reduce idiosyncratic exposure; nonsystematic is the risk that diversification eliminates.

5. Why the other options are incorrect
- “similar; nonsystematic”: Similar securities share the same exposures, so firm-specific shocks won’t cancel out; diversification fails.
- “similar; systematic”: Similar securities won’t remove systematic risk, and systematic risk is not what diversification targets.
- “different; systematic”: Even with many different securities, systematic (market) risk cannot be diversified away.

6. Conclusion
The correct choice is “different; nonsystematic,” which matches the provided answer.

A well-diversified portfolio is a portfolio that includes a large enough number of _ securities to make the _ risk negligible.Single choice

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A well-diversified portfolio is a portfolio that includes a large enough number of _____ securities to make the _____ risk negligible.Single choice