Diversification across Companies
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Diversification across Companies
Portfolio design is very important to effectively minimizing risk. When you invest, you can lose your money, although we don’t recommend that. One of the best ways to protect against losing all your money is to diversify your portfolio. Diversification summarizes the adage "Don’t put all your eggs into one basket." If you invest in one company, and that company goes belly-up, you stand to lose your investment. If you invest in two companies, you reduce the chances of losing all your money to 50%. But you do need to be careful. The risks inherent in an individual company are unsystematic risks, meaning that they apply only to that company. However, they may also apply to similar companies.
Things To Know
- The risks inherent in a company are unsystematic risks, meaning that they apply only to that company.
- If you diversify across industries, then risks that befall one industry may be less likely to affect others.
An example
It is important to consider how to reduce unsystematic risk if you want to create an effectively diversified portfolio. Let’s say you work for a book publishing company and want to buy stock in your company. If you only buy shares of your company and it falls on hard times, you stand to lose money. Since you know the book publishing industry, you decide to diversify and buy stock in several of your company’s competitors as well. However, some of the inherent risks of your company may also be inherent in the other companies in the book publishing industry. For example, what if all the book binders in the industry went on strike? The effects of such an event could lead the prices of all publishing stocks in that industry to plummet. Your holdings in publishing companies would be left at a deflated level. In this case you failed to identify the inherent (unsystematic) risks of each of the companies in which you invested.
If you diversified across industries ...
However, if you also had holdings in other industries such as oil, consumer durables, and electronics, it is less likely that the unsystematic risks in the publishing industry would adversely affect your other holdings. What is more, unfortunate circumstances in the book publishing business might result in a boom in other industries. The delays in the traditional print publishing business mentioned previously could cause people to publish materials in electronic form. If you held stock in an electronic publishing company, your stock might even benefit from the troubles that were slowing the growth of your holdings in the book publishing industry. Now you have diversified your portfolio, reducing the inherent risks of one or two companies and industries.
Know risk inside and out
In order to effectively diversify your portfolio, you need to consider the inherent risks of the companies in which you invest and try to select different companies and different industries to help reduce the possibility that all will share the same fate together. Diversification can lower risk by spreading your investment over several companies and industries.
