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Explanation: Close Explanation A When calculating the portfolio's risk, you have to consider the effect of the relationship between the security holdings in the portfolio. Thus, it cannot be calculated simply by taking the weighted average of the individual stocks' standard deviations. The portfolio's risk is likely to be smaller than the average of all stocks' standard deviations, because diversification lowers the portfolio's risk. Correlation is defined as the statistical relationship between two stocks. If two stocks move in the same direction, they are referred to as positively correlated stocks. The correlation coefficient (p) measures the degree to which two stocks are correlated. A p of +1.00 between the two means that both stocks will move in the exact same direction, and they are referred to as perfectly positively correlated stocks. A p of -1.00 between the two means that both stocks will move in the exact opposite direction, and they are referred to as perfectly negatively correlated stocks. A p of 0.00 means that returns of the two stocks are not related. Portfolio risk consists of market risk, also called systematic risk, and diversifiable risk, also called company-specific risk or unsystematic risk. Diversifiable risk represents the risk that is inherent to the stocks in the portfolio. It is risk associated with unexpected events that affect the returns associated with a particular stock. Some examples include lawsuits, strikes, or product failures. Market risk refers to the systematic risks in the equity markets that are affected by macroeconomic conditions and external factors. Diversifiable, or unsystematic, risk can be reduced by adding more securities to the portfolio. However, because systematic risk is associated with the entire market, risk can be reduced by investing in different markets through a process called hedging.