Illustrating Finance Policy with Mathematica : [PDF Download]

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“Diversification cannot eliminate risk in stocks because all stocks, as stakes in the underlying businesses, depend on a common source of risk, the overall performance of the economy. Granted, each stock carries significant risk that is particular to that business.

Damage to its productive assets, being overtaken by competitors’ innovations, personal difficulties of its key personnel, etc., are risks that influence that particular business. The financial literature calls them idiosyncratic or firm-specific risks.

The dependence of stocks on the common source of risk that is the overall economic performance makes them unlike pure gambles. Gambles such as the coin tosses of our example, have the feature of being independent, in probability theory language.

Such gambles are independent because their outcomes do not depend in any way on outcomes of other uncertainty, the other tosses. They have no relation to each other or to any common source of uncertainty.

By contrast, stocks are correlated and are not independent because their performance depends on the economy’s overall performance. When the economy booms and spending is forthcoming, all firms tend to do well. When the economy is in a recession and most cut spending, all firms tend to fare poorly.”

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