Final answer:
The risk of a diversified stock portfolio depends more on the covariance between the stocks than on individual variances. The concept of risk versus return is essential for investors, with stocks typically offering higher long-term returns at the cost of short-term volatility.
Step-by-step explanation:
When holding many stocks in a portfolio, the risk of that portfolio depends more on the covariance between the stocks than it depends on the individual stocks' variances. This is because the performance of any single stock is less significant than the way the stocks interact with one another. Diversification reduces the impact of any one stock's variance as the positive performance of some securities can offset the negative performance of others within a well-diversified portfolio.Understanding the relationship between risk and return is crucial for investors. Stocks offer potentially higher returns than bonds or savings accounts over the long term, but they also come with higher volatility in the short term. Young investors might prefer investing in mutual funds or stocks to leverage the higher long-term returns, whereas those closer to retirement might opt for lower-risk investments to ensure stability in their retirement income.
If you hold many stocks in a portfolio, the risk of that portfolio depends less on the covariance between the stocks in the portfolio, than it depends on the individual stocks' variances. This is because the covariance measures the degree to which the returns of two stocks move in relation to each other. When stocks in a portfolio have high covariance, their returns tend to move in the same direction, increasing the overall risk of the portfolio. On the other hand, when stocks have low covariance, their returns move independently, reducing the overall risk of the portfolio. Therefore, the covariance between stocks is a more important factor in determining the risk of a portfolio than the individual stocks' variances.