Join Jim Stice for an in-depth discussion in this video Reducing risk through diversification, part of Finance Fundamentals.
- We don't like risk--we have to be paid to bear risk. But some risk can be reduced through diversification. Diversification is just a fancy way of saying "Don't put all your eggs in one basket." If you put all your eggs in one basket and you trip, you've ruined all your eggs. But if you spread your eggs around, if you've diversified your risk, you've reduced your total risk. Professor Harry Markowitz won a Nobel Prize for mathematically proving this statement, "Don't put all your eggs in one basket." It's a way to reduce risk, spread things around.
Now, some risks are avoidable and some risks are unavoidable. For example, think about job risk. If I'm a construction worker, it's a risky place, a construction site. What if I went to work one day and said, "Listen, I want to expose myself to more risk "so that you'll have to pay me more. "I'm not going to put my hardhat on." You're not going to get paid more for that, because you're being stupid. You don't get paid extra for bearing additional risk when that risk is avoidable, as it would be in this case.
There are other employment risks that are unavoidable. If you are a deep-sea welder, there's risks associated with that job that cannot be avoided. There are snakes down there in the waters. You can get arterial gas poisoning. Oxygen poisoning--you can drown. Those risks cannot be avoided, therefore you're paid a little bit extra for that kind of risk. Don't expect to be paid extra for bearing risk that can be avoided. You can avoid a lot of risks by wearing a hardhat, you're not going to get paid extra for not wearing your hardhat because that is risk that's avoidable.
Companies have risks that can be avoided through diversification. Random bad things happen to companies, random good things happen to companies. What are some of these random bad things? A scandal, one of the top executives gets rolled up in a personal scandal. There's a big freak storm that destroys part of your production facility. Maybe there's an international event that cuts your supply chain. These are all random bad things. How about random good things? One random good thing is that something bad happens to your competitor. Or maybe an ordinary product breaks out. You sell hula hoops, which are just plastic hoops, but in 1958 and 1959 in the United States, all of a sudden everybody decided they needed a hula hoop and 100 million of them sold.
There was no rhyme or reason to that, it just happened, a random good thing. A chance discovery, penicillin, Velcro, Post-It Notes. Those were all random, good discoveries, random events that couldn't have been predicted. So random bad things happen to companies, random good things happen to companies. That's extra risk, but you're not going to get paid for bearing that risk because that risk can be eliminated or at least reduced through diversification. If I invest in one company, then I'm exposed to all kinds of risk from random good and bad events.
But if I spread my money out among 30 different companies, then the random bad things in one company will be balanced out by random good things in other companies. I can spread out or reduce my risk through diversification. Don't put all my eggs in one basket. Key points: I'm risk-averse. If you want me to bear risk, you're going to have to pay me extra. Diversification reduces risk. So I don't get paid for bearing risk that can be reduced or eliminated through diversification. I'm risk-averse, diversification reduces risk, I don't get paid extra for bearing risk that can be eliminated through diversification.
- Understanding financial statements
- Managing finances in the short term
- Analyzing risk and return
- Obtaining short-term and long-term financing
- Understanding the stock and bond markets
- Comparing the Facebook and Microsoft IPOs
- Working with financial institutions
- Using capital budgeting
- Creating simple personal saving and investment plans