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Chapter 6. Foolish Risks > How Much Diversification?

How Much Diversification?

How much diversification does it take to remove all, or most, of the firm-specific risk in a portfolio? As noted above, 70% of households held five stocks or fewer. Is this enough to avoid the concentration problems? You actually need many more stocks in your portfolio to remove the firm-specific risk.

In order to earn a high return, you must take market risk. We want to take market risk while avoiding firm-specific risk. This is because we are compensated for market risk, but not for firm-specific risk. If you own just one stock, you are taking both types of risk. In fact, most of the risk you are taking is firm-specific risk. However, if you add one randomly selected firm to the firm you hold, you reduce the total risk in your portfolio by 24%. This risk reduction is completely due to the reduction in firm-specific risk. Add two more randomly selected stocks and the total risk in your portfolio is only 60% of the risk of holding just one stock.


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