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NISM Certifications · NISM-Series-X-A: Investment Adviser (Level 1) · Introduction to Modern Portfolio Theory

Mr. Iyer, a client, holds a portfolio with 20 stocks across sectors and asks why adding more stocks no longer reduces his portfolio risk meaningfully. Which is the best explanation?

Most firm-specific risk has already been diversified away, so the remaining risk is mainly systematic market risk. Adding more stocks gives diminishing benefit because market-wide risk cannot be removed by diversification, and beta does not become zero.

  1. ADiversification eliminates systematic risk completely, so no more risk can be removed
  2. BMost diversifiable risk is already removed and the remaining risk is mainly systematic market riskCorrect
  3. CBeta of the portfolio becomes zero after 20 stocks
  4. DStandard deviation of each stock falls as more stocks are added

Explanation

Diversification removes unsystematic (firm-specific) risk, with diminishing benefit as stocks are added. What remains is systematic risk, which cannot be diversified away. Diversification does not eliminate systematic risk or make beta zero.

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