If investors are rational, they should fully diversify by holding the market portfolio, which is the portfolio of all risky securities available for investment.
Securities, which refer to stocks and bonds, have two primary types of risks: diversifiable and undiversifiable. The diversifiable risk of a security is the risk that arises from the specific performance of the company. If investors hold diversified portfolios, this risk can be completely eliminated. All investors should hold the most broadly diversified portfolios possible. These broadly diversified portfolios, however, will be subject to whatever risks remains that reflects the common risks of these companies. These common risks are said to be undiversifiable and are generally related to the economy as a whole.
A portfolio that is so broad that all of the diversifiable risk is eliminated is typically considered to be the portfolio of all risky securities in the market and is often called the market portfolio. As a practical matter, it is impossible to hold the true market portfolio, but very broadly diversified mutual funds are not only available, but are widely held by investors.
Diversifiable risk is also called specific risk, unique risk, idiosyncratic risk, and unsystematic risk. Undiversifiable risk is also called market risk and systematic risk.
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Last updated: January 9, 2011