A Portfolio is a group of financial assets including stocks, bonds etc. which is held by an investor or an Institution. The construction of portfolio is always desired to be diversified, where the assets are included in the portfolio, on the basis of their correlation. This process of portfolio construction is known as ‘’Portfolio Construction’’ where only diversified assets are included so as to reduce the unsystematic risk in the portfolio.
In other words, as per Markowitz Portfolio Theory, a portfolio comprise of Systematic Risk + Unsystematic Risk, however it is only the unsystematic risk that can be diversified through portfolio diversification. Thus, a prudent asset manager will include only those assets that are not perfectly correlated to each other. This is because as when an investor diversifies across assets that are not perfectly correlated, the portfolio’s risk turns less than the weighted average of the risks of the individual securities in the portfolio. Thus, the risk that is eliminated with the help of diversification process is the unsystematic risk and the risk that is left and cannot be diversified is called the systematic risk.
Hence, it is concluded that, a well diversified portfolio will always contain the asset classes that are not perfectly correlated to each other. Furthermore, the asset manager do not need to purchase all the securities available in the market to eliminate the unsystematic risk. Academic Research has proved that as more number of non-correlated securities are added to the portfolio, the portfolio risk falls toward the level of market risk and it takes only 30 securities in the portfolio to reach zero unsystematic risk and what is left after that level is the constant systematic risk.
Works Cited
O'Connor. (2011). Portfolio Risk and Revenue: Part II. In C. Institute, Portfolio Investments (pp. 170-174). Boston: Custom.
