Final answer:
According to CAPM, there is a direct relationship between risk and return, where higher risk is associated with higher expected return. Diversification helps reduce unsystematic risk but not systemic risk, which CAPM measures with beta. Diversification across a variety of assets can lead to portfolio stability over time.
Step-by-step explanation:
The relationship between risk and return according to the Capital Asset Pricing Model (CAPM) posits that the expected return on an investment is proportional to its risk, which is measured by beta (β). Beta reflects how much the investment's returns are expected to respond to market movements. In other words, a higher beta implies more substantial exposure to systemic risk and hence demands a higher expected return as compensation.
Diversification is the process of allocating capital in a way that reduces exposure to any one particular asset or risk. A well-diversified portfolio has a variety of assets, which typically results in reduced portfolio risk. According to CAPM, diversification helps in mitigating unsystematic risk, which is the risk associated with individual stocks. However, systemic risk, which affects the entire market, cannot be diversified away and is the primary risk measured by the CAPM.
In practical terms, diversification allows investors to reduce their portfolio's volatility without necessarily diminishing expected returns. By including a mix of assets that react differently to various economic conditions, investors can achieve a more stable return over different time frames, thus balancing their individual preferences for risk and return.