Asset Allocation & Portfolio Management: limits to diversification

We have seen in the previous section that portfolio risk can be sharply reduced by diversification but can the portfolio risk be completely eliminated by diversification?

Unfortunately the answer is NO.

We have seen that diversification works because stock prices are imperfectly correlated. To explain why risk cannot be fully eliminated by diversification, we have to analyze the various risks you are facing when investing in a security:

1. Unique risk (also called unsystematic risk, residual risk or specific risk). This risk encompass all the perils that surround a particular company and can be sharply reduced by diversification.

2. Market risk (also called systematic risk). This risk stems from the fact there are economy-wide perils (macroeconomic factors) which threaten the business. Within an asset class, this risk cannot be reduced by diversification.

The above concept can be illustrated by the following graph:

In the next section, we will see how we can measure the price sensibility of an individual security compared to the market (Beta).

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