â¢ MARCH 1975 THE EFFECT OF MARKET RISK ON PORTFOLIO DIVERSIFICATION ROBERT C. KLEMKOSKY AND JOHN D. MARTIN* FEW INVESTORS would disagree that risk should be an integral part of investment and portfolio analysis. The beta coefficient of the market model has had wide acceptance by academicians in recent years as the relevant risk measure. Theoretical justification for this risk measure can be derived from the portfolio approach which makes the basic assumption that investors evaluate the risk of a portfolio as a whole rather than the risk of each asset individually. Furthermore, the portfolio approach concludes that the risk of a portfolio should be measured by the covariability of its returns with the returns of the market portfolio. Thus the market risk of an individual security, as it contributes to the portfolio covariability, is the appropriate measure of risk for that security since nonmarket related risk can be eliminated by the aggregation of securities in a portfolio. Evans and Archer  found that the process of diversification proceeds rapidly as portfolio size increases, with most of the effect of diversification having taken place with the aggregation of only eight to ten securities. However, recent evidence by Miller
The Journal of Finance – Wiley
Published: Mar 1, 1975
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