Meaning of Diversification

150 words each comment. 1) Please describe the meaning of diversification. How does diversification reduce risk for the investor?

2) What is the opportunity cost of capital? How can a company measure opportunity cost of capital for a project that is considered to have average risk?

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post 1:Diversification is a process of reducing the risk by spreading out the investments across various financial instruments and other categories. In other words, it means adding assets to an investment portfolio in order to decrease the entire risk factor of the portfolio while keeping the return as high as possible. This technique reduces the risk of an investment because it mitigates the specific risk that is related to a particular individual investment. If you keep adding various investments across different industries and sectors the portfolio risk could theoretically reach a level as low as the market risk. “Investors who over-weight stocks with higher volatility and higher skewness are less diversified” Goetzmann W. N, Kumar A. 2008.

2) Opportunity cost is an economic term, which means to account for all the outcomes you give up by selecting one outcome. For example, the opportunity cost of playing videogames on a Friday night is the sum of other possible scenarios; going on a date, binging your favorite Netflix show, or even sleeping early. Normatively, consumers should incorporate opportunity costs into every decision they make, yet behavioral research suggests that consumers consider them rarely, if at all (Spiller S. A. 2011).

In finance, the opportunity cost of capital represents the difference in the investment choice that an individual or company makes compared to one that they did not make. A very good example I can think of is the opportunity cost of buying Bitcoin in the crypto market is the not buying of Ethereum from the same broker or not buying at all. Investing $1,000 of Bitcoin generates the opportunity cost of not buying any stock, crypto, forex pair, security, commodity or any other financial instrument that can possibly give greater returns. Companies measure the opportunity cost of two investments by establishing which parameters they have similarities in, in this case, risk. Consumers who consider opportunity costs are less likely to buy focal options than those who do not when opportunity costs are appealing, but no less likely when opportunity costs are unappealing (Spiller S. A. 2011).

Reference:

Goetzmann W. N, Kumar A. 2008, Equity Portfolio Diversification, Review of Finance, 12, (3), 433–463

Spiller S. A. 2011, Opportunity Cost Consideration, Journal of Consumer Research, 38, (4), 595–610.

post 2:

Diversification is a strategy designed to reduce risk by spreading the portfolio across many investments. It also means owning a range of assets across a variety of industries, company sizes and geographic areas. It’s part of what is called asset allocation, meaning how much of a portfolio is invested in various asset classes. Investors have many options, and each has advantages and disadvantages, responding differently across the economic cycle. The main aim of diversification is to maximize return by investing in different areas that would each react differently to the same event. Investments have two broad types of risk:

Asset-specific risks: These risks come from the investments or companies themselves. Such risks include the success of a company’s products, the management’s performance, and the stock’s price. Market risks: These risks come with owning any asset, even cash. The market may become less valuable for all assets, due to investors’ preferences, a change in interest rates or some other factor such as war or weather.

How does diversification reduce risk for the investor?

Diversification provides various tools for reducing overall risk while increasing the potential for overall return. That’s because some assets will perform well while others do poorly. Regardless of which stocks are the winners, a well-diversified stock portfolio tends to earn the market’s average long-term historic return about 10% annually. Diversification refers to a risk management technique that involves mixing a wide variety of investments within a portfolio. Generally, as the number of assets in a portfolio increases, the risk of that portfolio decreases. Assets are organized into classes such as equities, property, cash and fixed-interest securities including bonds. Effective asset allocation will see your investment funds split across multiple asset classes to help balance risk and potential rewards.

An investor can therefore reduce the risk of his or her investments by investing in two or more assets whose values do not always move in the same direction at the same time. This is because the movements in the values of the different investments will partially cancel each other out.

In addition to reducing the risk for the investor through diversification, many share market experts recommend balancing share investments across different industry sectors. Typical sectors include resources like iron and gold, financials, communications, energy, technology, and others. By splitting your share portfolio across sectors, you can help balance the normal ups and downs these sectors may experience, and their impact on your portfolio, (Brealey, Myers, & Marcus, 2015)

Opportunity cost of capital is the incremental return on investment that a business foregoes when it elects to use funds for an internal project, rather than investing cash in a marketable security. Thus, if the projected return on the internal project is less than the expected rate of return on a marketable security, one would not invest in the internal project, assuming that this is the only basis for the decision. The opportunity cost of capital is the difference between the returns on the two projects, (Accounting Tools, 2021).

Senior management may be certain that the company can generate an 8% return on the new manufacturing facility, whereas there may be considerable uncertainty regarding the variability of returns from an investment in stocks which could even be negative during the cash usage period. Thus, the variability of returns should also be considered when arriving at the opportunity cost of capital, (Accounting Tools, 2021). This uncertainty can be quantified by assigning a probability of occurrence to different return on investment outcomes and using the weighted average as the most likely return. No matter how the issue is addressed, the main point is that there is uncertainty surrounding the derivation of the opportunity cost of capital, so that a decision is rarely based on completely reliable investment information, (WSJ, 2021).

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