A random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing

HOW 
DIVERSIFICATION
REDUCES 
RISK: 
RISK 
OF
PORTFOLIO 
(STANDARD
DEVIATION OF RETURN)

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Now comes the key step in the argument. Financial
theorists and practitioners agree that investors should be
compensated for taking on more risk with a higher expected
return. Stock prices must, therefore, adjust to offer higher
returns where more risk is perceived, to ensure that all
securities are held by someone. Obviously, risk-averse
investors wouldn’t buy securities with extra risk without the
expectation of extra reward. But not all of the risk of

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individual securities is relevant in determining the premium
for bearing risk. The unsystematic part of the total risk is
easily eliminated by adequate diversification. So there is no
reason to think that investors will receive extra compensation
for bearing unsystematic risk. The only part of total risk that
investors will get paid for bearing is systematic risk, the risk
that diversification cannot help. Thus, the capital-asset
pricing model says that returns (and, therefore, risk
premiums) for any stock (or portfolio) will be related to beta,
the systematic risk that cannot be diversified away.
THE CAPITAL-ASSET PRICING
MODEL (CAPM)
The proposition that risk and reward are related is not new.
Finance specialists have agreed for years that investors do
need to be compensated for taking on more risk. What is
different about the new investment technology is the
definition and measurement of risk. Before the advent of the
capital-asset pricing model, it was believed that the return on
each security was related to the total risk inherent in that
security. It was believed that the return from a security varied

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with the variability or standard deviation of the returns it
produced. The new theory says that the total risk of each
individual security is irrelevant. It is only the systematic
component that counts as far as extra rewards go.
Although the mathematical proof of this proposition is
forbidding, the logic behind it is fairly simple. Consider two
groups of securities—Group I and Group II—with sixty
securities in each. Suppose that the systematic risk (beta) for
each security is 1; that is, each of the securities in the two
groups tends to move up and down in tandem with the
general market. Now suppose that, because of factors
peculiar to the individual securities in Group I, the total risk
for each of them is substantially higher than the total risk for
each security in Group II. Imagine, for example, that in
addition to general market factors the securities in Group I are
also particularly susceptible to climatic variations, to changes
in exchange rates, and to natural disasters. The specific risk
for each of the securities in Group I will, therefore, be very
high. The specific risk for each of the securities in Group II,
however, is assumed to be very low, and, hence, the total risk
for each of them will be very low. Schematically, this
situation appears as follows:

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Group I (60 Securities)
Group II (60 Securities)
Systematic risk (beta) = 1 for
each security
Systematic risk (beta) = 1 for
each security
Specific risk is high for each
security
Specific risk is low for each
security
Total risk is high for each
security
Total risk is low for each
security
Now, according to the old theory, commonly accepted
before the advent of the capital-asset pricing model, returns
should be higher for a portfolio made up of Group I
securities, because each security in Group I has a higher total
risk than each security in Group II, and risk, as we know, has
its reward. With a wave of their intellectual wands, the
academics changed that sort of thinking. Under the capital-
asset pricing model, returns from the two portfolios should
be equal. Why?
First, remember the preceding chart