8.2 Systematic Risk and the Market Portfolio
In the last section, we showed that the correlation between the returns of two stocks in a portfolio plays a key role in determining the overall risk of the portfolio. The intuition that combining imperfectly correlated investments into a portfolio reduces risk also applies to portfolios that include many different investments. In particular, those investments whose returns have low correlations with other investments in the portfolio contribute less to the overall riskiness of a diversified portfolio than those investments whose returns are highly correlated with the other investments in the portfolio.
This logic implies that the standard deviation of an individual investment is not the best measure ...
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