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Diversifying Across Companies Risk doesn't necessarily have to specific to an industry—it's often present at a company-specific level. Imagine a company with a revolutionary leader. Should that leader leave the company or pass away, the company will be negatively impacted. Risk specific to a company can occur regarding legislation, acts of nature, or consumer preference.
Therefore, you might have your favorite airline you personally choose to always fly with. However, if you're a strong believer in the future of air travel, consider diversifying by acquiring shares of a different airline provider as well. Diversifying Across Asset Classes So far, we've only discussed stocks. However, different asset classes act differently based on broad macroeconomic conditions. For example, if the Federal Reserve raises interest rates, equity markets may still perform well due to the relative strength of the economy.
However, rising rates decrease bond prices. Therefore, investors often consider splitting their portfolios across a few different asset classes to protect against widespread financial risk. More modern portfolio theory suggests pulling in alternative assets, an emerging asset class that goes beyond investing in stocks and bonds. With the rise of digital technology and accessibility, investors can now put money into real estate, cryptocurrency, commodities, precious metals, and other assets with ease.
Again, each of these classes have different levers that dictate what makes them successful. Investing in these types of indices is an easy way to diversify. Diversifying Across Borders Political, geopolitical, and international risks have worldwide impacts, especially regarding the policies of larger nations.
However, different countries operating with different monetary policy will provided different opportunities and risk. For instance, imagine how a legislative change to U. For this reason, consider broadening your portfolio to include companies and holdings across different physical locations. Diversifying Across Time Frames When considering investments, think about the time frame in which they operate.
For instance, a long-term bond often has a higher rate of return due to higher inherent risk, while a short-term investment is more liquid and yields less. An airline manufacturer may take several years to work through a single operating cycle, while your favorite retailer might post thousands of transactions using inventory acquired same-day. Real estate holdings may be locked into long-term lease agreements.
In general, assets with longer timeframes carry more risk but often higher returns to compensate for that risk. In addition, it is impossible to reduce all risks in a portfolio; there will always be some inherent risk to investing that can not be diversified away. There is discussion over how many stocks are needed to reduce risk while maintaining a high return. The most conventional view argues that an investor can achieve optimal diversification with only 15 to 20 stocks spread across various industries.
Other views contest that 30 different stocks are the ideal number of holdings. The Financial Industry Regulatory Authority FINRA states diversification is specific to each individual and to consider the decision after consulting an investment professional or using your own judgment. For investors that might not be able to afford holdings across 30 different companies or for traders that want to avoid the transaction fees of buying that many stocks, index funds are a great choice.
By holding this single fund, you gain partial ownership in all underlying assets of the index, which often comprises dozens if not hundreds of different companies, securities, and holdings. Different Types of Risk Investors confront two main types of risk when they invest.
The first is known as systematic or market risk. This type of risk is associated with every company. Common causes include inflation rates, exchange rates , political instability, war, and interest rates. This category of risk is not specific to any company or industry, and it cannot be eliminated or reduced through diversification.
It is a form of risk that all investors must accept. The second type of risk is diversifiable or unsystematic. This risk is specific to a company, industry, market, economy , or country. The most common sources of unsystematic risk are business risk and financial risk. Because it is diversifiable, investors can reduce their exposure through diversification.
Thus, the aim is to invest in various assets so they will not all be affected the same way by market events. Systematic risk affects the market in its entirety, not just one particular investment vehicle or industry. Benefits of Diversification Diversification attempts to protect against losses.
This is especially important for older investors that need to preserve wealth towards the end of their professional careers. It is also important for retirees or individuals approaching retirement that may no longer have stable income; if they are relying on their portfolio to cover living expenses, it is crucial to consider risk over returns. Diversification is thought to increase the risk-adjusted returns of a portfolio.
This means investors earn greater returns when you factor in the risk they are taking. Investors may be more likely to make more money through riskier investments, but a risk-adjusted return is usually a measurement of efficiency to see how well an investor's capital is being deployed.
Some may argue diversifying is important as it also creates better opportunities. In our example above, let's say you invested in a streaming service to diversify away from transportation companies. Then, the streaming company announces a major partnership and investment in content. Had you not been diversified across industries, you would have never reaped the benefit of positive changes across sectors.
Last, for some, diversifying can make investing more fun. Instead of holding all of your investment within a very small group, diversifying means researching new industries, comparing companies against each other, and emotionally buying into different industries. Problems With Diversification Professionals are always touting the importance of diversification but there are some downsides to this strategy.
First, it may be somewhat cumbersome to manage a diverse portfolio, especially if you have multiple holdings and investments. Modern portfolio trackers can help with reporting and summarizing your holdings, but it can often be cumbersome needing to track a larger number of holdings. This also includes maintaining the purchase and sale information for tax reasons.
Diversification can also be expensive. Product Development Secondary. A strategic objective of product development in this case is to grow the business through new products, such as new electronic gadgets. For example, the company regularly rolls out new smartphone models, similar to what Apple Inc. Market Development. With the strategic objective of establishing new profitable businesses, the diversification strategy grows Samsung typically through acquisitions of smaller firms, such as Harman International Industries.
The minor role designation of this intensive growth strategy limits the risks of establishing new business operations. References Akwetey, L. In Global Enterprise Management pp. Palgrave Macmillan, New York. What have we learned about generic competitive strategy? A meta-analysis.
Strategic Management Journal, 21 2 , Douglas, S. Examining generic competitive strategy types in US and European markets. Journal of International Business Studies, 20 3 , Filatotchev, I. Management and Organization Review, 13 3 , Herbert, T. Generic strategies: An empirical investigation of typology validity and strategy content.
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