If a risky stock is added to a well-diversified portfolio, what is likely to happen?

When a risky stock is added to a well-diversified portfolio, the impact on the overall risk of the portfolio largely depends on the correlation of that stock with the existing assets in the portfolio. If the new stock has a negative correlation with the other assets, it means that when some assets are performing poorly, the new stock is likely to perform well. This negative correlation can provide a hedging effect that reduces the overall risk of the portfolio.

In a well-diversified portfolio, risk is typically measured by the amount of unsystematic risk, which can be diversified away. By adding an asset that behaves differently from the assets already in the portfolio (particularly one that negatively correlates), investors can potentially lower the overall variance of the portfolio's returns, thereby decreasing risk.

This phenomenon highlights the importance of correlation in portfolio management. Options that suggest consistent increases in risk or decreased returns fail to account for the potential for diversification benefits that arise from strategically selecting assets with varying correlations. Therefore, adding a negatively correlated risky stock can actually enhance the overall stability of the portfolio.