*Register to read the introduction…*For example, if σ = 45% and ρ = 0.2, then the standard deviation with 50 stocks would be 20.91%, and would rise to 22.05% when only 20 stocks are held. Such an increase might be acceptable if the expected return is increased sufficiently. Hennessy could contain the increase in risk by making sure that he maintains reasonable diversification among the 20 stocks that remain in his portfolio. This entails maintaining a low correlation among the remaining stocks. For example, in part (a), with ρ = 0.2, the increase in portfolio risk was minimal. As a practical matter, this means that Hennessy would have to spread his portfolio among many industries; concentrating on just a few industries would result in higher correlations among the included stocks. 2. Risk reduction benefits from diversification are not a linear function of the number of issues in the portfolio. Rather, the incremental benefits from additional diversification are most important when you are least diversified. Restricting Hennessy to 10 instead of 20 issues would increase the risk of his portfolio by a greater amount than would a reduction in the size of the portfolio from 30 to 20 stocks. In our example, restricting the number of stocks to 10 will increase the standard deviation to 23.81%. The 1.76% increase in standard deviation resulting from giving up 10 of 20 stocks is greater than the 1.14% increase that results from giving up 30 of 50 stocks. The point is well taken because the committee should be concerned with the volatility of the entire portfolio. Since Hennessy’s portfolio is only one of six well-diversified portfolios and is smaller than the average, the concentration in fewer issues might have a minimal effect on the diversification of the total fund. Hence,

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The total risk of a portfolio, or portfolio variance, is the combination of systematic risk and firm-specific risk. The systematic component depends on the sensitivity of the individual assets to market movements as measured by beta. Assuming the portfolio is well diversified, the number of assets will not affect the systematic risk component of portfolio variance. The portfolio beta depends on the individual security betas and the portfolio weights of those securities. On the other hand, the components of firm-specific risk (sometimes called nonsystematic risk) are not perfectly positively correlated with each other and, as more assets are added to the portfolio, those additional assets tend to reduce portfolio risk. Hence, increasing the number of securities in a portfolio reduces firm-specific risk. For example, a patent expiration for one company would not affect the other securities in the portfolio. An increase in oil prices might hurt an airline stock but aid an energy stock. As the number of randomly selected securities increases, the total risk (variance) of the portfolio approaches its systematic