Portfolio Risk, Diversification, and Beta

Portfolio risk encompasses two main components: systematic risk, which affects the entire market, and unsystematic risk, which is asset-specific. Effective risk management involves diversification-spreading investments across assets with low or negative correlations to minimize unsystematic risk. The variance of a two-asset portfolio is calculated by considering weights, individual variances, and their covariance: $\sigma_p^2 = w_1^2 \sigma_1^2 + w_2^2 \sigma_2^2 + 2w_1 w_2 Cov(1,2)$. Beta () measures an asset's sensitivity to market movements, calculated as . A portfolio's beta is the weighted sum of its assets' betas: . While diversification reduces unsystematic risk, systematic risk remains and is captured by beta, for which investors demand compensation. Understanding these concepts is critical for accountants advising on asset allocation, financial stability, cost of capital, and aligning investments with client risk tolerance.