How Diversification Reduces or Eliminates Firm-Specific Risk
##### First, each investment in a diversified portfolio represents only a small percentage of that portfolio. Thus, any risk that increases or reduces the value of that particular investment or group of investments will only have a small impact on the overall portfolio. Second, the effects of firm-specific actions on the prices of individual assets in a portfolio can be either positive or negative for each asset for any period. Thus, in large portfolios, it can be reasonably argued that positive and negative factors will average out so as not to affect the overall risk level of the total portfolio. The benefits of diversification can also be shown mathematically: σ^2portfolio= WA^2σA^2 + WB^2σB^2 + 2WA WBр ABσ AσB Where: σ = standard deviation W = weight of the investment A = asset A B = asset B р = covariance Other things remaining equal, the higher the correlation in returns between two assets, the smaller are the potential benefits from diversification.
Comparative Analysis of Risk and Return Models
• The Capital Asset Pricing Model (CAPM)
• APM
• Multifactor model
• Proxy models
• Accounting and debt-based models