How is the standard deviation of returns for individual common stocks or for a stock portfolio calculated?
The spread of outcomes on different investments is commonly measured by the variance or standard deviation of the possible outcomes. The variance is the average of the squared deviations around the average outcome, and the standard deviation is the square root of the variance. The standard deviation of the returns on a market portfolio of common stocks has averaged 20 percent a year. Why does diversification reduce risk? The standard deviation of returns is generally higher on individual stocks than it is on the market. Because individual stocks do not move in exact lockstep, much of their risk can be diversified away. By spreading your portfolio across many investments, you smooth out the risk of your overall position. The risk that can be eliminated through diversification is known as unique risk. What is the difference between unique risk, which can be diversified away, and market risk, which cannot? Even if you hold a well-diversified portfolio, you will not eliminate all risk. You
