Which of the following portfolios might be expected to exhibit less unique risk?

Question

A) Five different stocks; portfolio beta = .8.
B) Three different stocks; portfolio beta = 1.2.
C) Ten different stocks; portfolio beta = 1.0.
D) Twelve different stocks; portfolio beta unknown

Answer 1

The Beta measures market risk -- and does not measure company specific risk -- so you can ignore the betas of the portfolios.

The key here is that you lessen company specific risk by diversifying the portfolio. Portfolio (B) only has three stocks -- so is the least diversified.

Note that as the question is stated, there is no right answer. (B) is correct if you are putting equal amounts of money in each stock. However, if I had a portfolio with $25 invested in each of 99 stocks and $1MM in one other stock, I would be less diversified than if I had 1/3 of my money in each of three stocks.