So let's take a look at sort of the relationships then between risk and
the types of investment.
So we'll start off with the risk-free investment over here, the treasury bills.
We move on up and think of money market securities, intermediate,
large corporate stock, small corporate stocks, real estate, foreign investments.
So what we see is that we go from having no risk to taking on a lot more risk, but
also having a lot more expected return as a result.
The security market line does assume that we're dealing with a diversified set of
investments though.
It's not to say that if you have any one of these, you would see this pattern.
If you had one T-bill, one, one short-term debt,
one large stock, one small stock, if you just stack them all up, you might not see
this pattern because that's not the intention of the SML, right?
The intention is to understand that in diversified portfolios,
we might often see this pattern and it's what we typically have seen over time.
Now, let's look at diversification then, illustrated if you will, and
this is from one of my favorite books by Herbert Mayo.
Right, if we take a look within here, we have the number of securities on
the bottom and, of course, on the upper axis, the y-axis, we have risks.
So what we see, right, is that a curved line, right?
So if we look at line CD, the curve that's happening there,
we see that that represents the line under which we have the total portfolio risk.
Now, remember,
portfolio risk was separated into two components, systematic and unsystematic.
So the systematic risk, you'll note, right, the line,
the top line AB doesn't change.
So, regardless of the number of securities we have, AB stays a flat line across.
Meaning that the diversified,
the non-diversifiable risk really doesn't change no matter what we do.
We're going to be exposed to it.
When we're exposed to it, that's going to be a good thing, right?
Because it means we can expect a reward, assuming we're diversified.
But note what happens to unsystematic risk.
The greater the number of unrelated securities that we
place into the portfolio, the more we reduce and
virtually eliminate unsystematic or diversifiable risk.
Now, I say virtually because,
mathematically, it's probably never going to actually go to zero.
But it does mean that we can really reduce the effects that we would see so
that no one investment can be truly devastating to our portfolio.
But again, an overall market downturn is still going to hurt us.
So that's going to be hard to avoid.
Now, it's important that we also get a sense of these overall investments.
So when we look at how companies respond and
what their overall growth is, why do we need to have asset allocation?
So, asset allocation is partially how we're going to achieve diversification
because not only do we want to have a bundle of the different types of assets,
if we're mostly in stocks, we need to be in a broad number of stocks.
If we're mostly in bonds, we need to have a broad number of bonds.
So, as we look through these, it's important to kind of note why it's so
important to build these up.
Let's say that in 1925, you went out and bought $1 of goods, an apple,
an orange, maybe some bread and some milk, and that cost you a buck.
Well, in 2005, for example, that would have cost you $11.
That's a 3% rate of increase over that 80-year period.