as mentions before, there are 3 ways to commonly reduce risks. which is diversification, insurance and obtaining more information about choices and the payoffs
Diversification itself means practice of reducing risk by allocating resources to a variety of activities whose outcomes are not closely related.
ofcourse with diversification, an investor itself reduces much risk by investing in many others related assets. risks can be minimized by allocating your time so that you sell two or more products (which sales are not closely related) rathen than a single product.
for an easy example, income from Sales of Appliances ($) in hot weather, AC sales 30.000 & Heater sales 12.000 in cold weather, AC sales 12.000 & Heater sales 30.000 and there is same probability, a 50% (0.5) that will be a hot year, and also a 50% (0.5) that will be a cold year. if you sell only a AC or only a Heater, your actual income will be only either $12.000 or $30.000 and your expected income only $21.000 because EV : (0.5)($30.000)+(0.5)($12.000) but if you diverse it by dividing evenly between AC and Heater in this case you will earn $21.000 regardless of the weather. if the weather is hot you will earn $15.000 from ACs and $6000 from Heaters. and if it is cold you will earn $6000 from ACs and $15.000 from Heaters.
by this chance, diversification eliminates all risk.
In finance, diversification means reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of its constituent. The simplest example of diversification is provided by the proverb "Don't put all your eggs in one basket". Dropping the basket will break all the eggs. Placing each egg in a different basket is more diversified. There is more risk of losing one egg, but less risk of losing all of them. In finance, an example of an undiversified portfolio is to hold only one stock. This is risky; it is not unusual for a single stock to go down 50% in one year. It is much less common for a portfolio of 20 stocks to go down that much, especially if they are selected at random. If the stocks are selected from a variety of industries, company sizes and types it is still less likely.
An investor reduces risk by investing in many assets whose returns are not highly correlated and, even better, some whose returns are negatively correlated. A mutual fund, for example, is a portfolio of stocks of many different companies. If the rate of return on each company’s stock is not highly related to the rates of return earned on the other stocks in the portfolio, the portfolio will have a lower variance than any of the individual stocks. This occurs because low returns on some stocks tend to be offset by high returns on others. As the number of stocks in the portfolio increases, the portfolio’s variance decreases. While there is less risk in a portfolio of stocks, risk cannot be completely avoided; there is still some market risk in holding a portfolio of stocks compared to a low-risk asset, such as a U.S. government bond.
as mentions before, there are 3 ways to commonly reduce risks. which is diversification, insurance and obtaining more information about choices and the payoffs
ReplyDeleteDiversification itself means practice of reducing risk by allocating resources to a variety of activities whose outcomes are not closely related.
ofcourse with diversification, an investor itself reduces much risk by investing in many others related assets. risks can be minimized by allocating your time so that you sell two or more products (which sales are not closely related) rathen than a single product.
for an easy example,
income from Sales of Appliances ($)
in hot weather, AC sales 30.000 & Heater sales 12.000
in cold weather, AC sales 12.000 & Heater sales 30.000
and there is same probability, a 50% (0.5) that will be a hot year, and also a 50% (0.5) that will be a cold year.
if you sell only a AC or only a Heater, your actual income will be only either $12.000 or $30.000 and your expected income only $21.000 because EV : (0.5)($30.000)+(0.5)($12.000)
but if you diverse it by dividing evenly between AC and Heater in this case you will earn $21.000 regardless of the weather.
if the weather is hot you will earn $15.000 from ACs and $6000 from Heaters. and if it is cold you will earn $6000 from ACs and $15.000 from Heaters.
by this chance, diversification eliminates all risk.
In finance, diversification means reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of its constituent.
ReplyDeleteThe simplest example of diversification is provided by the proverb "Don't put all your eggs in one basket". Dropping the basket will break all the eggs. Placing each egg in a different basket is more diversified. There is more risk of losing one egg, but less risk of losing all of them. In finance, an example of an undiversified portfolio is to hold only one stock. This is risky; it is not unusual for a single stock to go down 50% in one year. It is much less common for a portfolio of 20 stocks to go down that much, especially if they are selected at random. If the stocks are selected from a variety of industries, company sizes and types it is still less likely.
GUIDELINE ANSWER:
ReplyDeleteAn investor reduces risk by investing in many assets whose returns are not highly correlated and, even better, some whose returns are negatively correlated. A mutual fund, for example, is a portfolio of stocks of many different companies. If the rate of return on each company’s stock is not highly related to the rates of return earned on the other stocks in the portfolio, the portfolio will have a lower variance than any of the individual stocks. This occurs because low returns on some stocks tend to be offset by high returns on others. As the number of stocks in the portfolio increases, the portfolio’s variance decreases. While there is less risk in a portfolio of stocks, risk cannot be completely avoided; there is still some market risk in holding a portfolio of stocks compared to a low-risk asset, such as a U.S. government bond.