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  • Explain why the total risk of a portfolio is not simply equal to the weighted average of the risks of the securities in the portfolio.
 

Sunday, 23 June 2019 / Published in Business and Management, Solutions

Explain why the total risk of a portfolio is not simply equal to the weighted average of the risks of the securities in the portfolio.

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The total risk of a portfolio – comprised of eclectic combination of securities cannot be equal to the weighted average because of the individual securities’ ‘Specific risks’. This risk is intrinsic to the security, and they are always reduced via a healthy diversification. The underlying reason is that specific risks tend to nullify each other. Besides a specific risk is unique and random.

On the other hand tha risk that comes with portfolios is called a Systematic risk (or market risk). This risk is not the weighted average of the individual securities, but the risk common to all securities. Within a market portfolio, risk that is specific to an asset will be diversified as much as possible. Therefore the value of this kind of risk – in question here – is equal to the risk (standard deviation) of the market portfolio.

A security is preferred only if reduces the net risk of a market portfolio. Therefore, the important measure of it’s risk is what it adds, and not the risk value by itself (in isolation). In this way, Systematic risks in a market may be manipulated by using long as well as short positions in a portfolio. This creates a “market neutral” risk portfolio!

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