About Portfolio Risk

A portfolio's risk consists of "systematic," or "market" risk, and "non-systematic," or "stock-specific" risk. A 10-stock portfolio would have the same systematic risk as a 100-stock portfolio, but the smaller portfolio has more stock-specific risk because it's less diversified.

Unfortunately, the only risk category that gets rewarded with higher expected returns is systematic risk (which is identical for both portfolios). The market doesn't reward a failure to diversify with higher expected returns.

In a situation where the same stock is being held in a 10-stock or a 100-stock portfolio, if the stock doubles in price, it's effect on actual performance (after-the-fact returns, not expected returns) will depend on the stock's weight in each portfolio -- if it's 10% of the 10-stock portfolio and 1% of the 100-stock portfolio, the smaller portfolio would outperform the larger. But if the stock was 10% of both portfolios, the performance effect is identical.

But the key point is that actual (after the fact) returns may be higher or lower than expected. In the long run, the 10-stock portfolio is more risky, but it's not guaranteed a higher return as a result -- it's just as possible that the single stock could fall by half.

* * * * *