Portfolio risk, market risk or systematic risk cannot be reduced by increasing t
ID: 2643607 • Letter: P
Question
Portfolio risk, market risk or systematic risk cannot be reduced by increasing the number of securities. Unsystematic risk can be reduced by adding more securities. Can you provide examples of systematic and unsystematic risk? Why do we need to have the covariance less than the variance of the securities? And we know that the variance of the portfolio asymptotically approaches covariance; each additional security will reduce risk. Why?
I get unsystematic and systematic risk. And I understand covariance to the point of moving together in a positive or negative direction. But I don't understand the part from having covariance less than variance and down. Help please.
Explanation / Answer
The covariance between the securities of a portfolio measures the relationship between the securities, it may be negative, positive or zero. The positive covariance between the securities increase the risk of the portfolio therefore the negative covariance is always preferable by the investors. If the variance of portfolio increases due to addition of a new security, it means the investor is not getting the advantage of diversification. Therefore, the covariance between the securities should be less than the variance of individual securities.