PART2 | KEY PRINCIPLES OF FINANCE
CHAPTER3 | RISK DIVERSIFICATION
“Don't put all your eggs in one basket”. This is probably the most famous idiom that we hear in finance. Regardless of how many time you heard of this cliché, the importance of underlying message is never enough to emphasize. Let’s take a look at an example and see how this relates to finance.
Here, RJ is walking on the street with a basket full of eggs on his hand.
Oops! RJ dropped the basket, and lost all of his eggs. RJ did not expect to bump into someone on the street, so he was not prepared.
As we all know, unexpected events occur at various points in life. It is practically impossible to anticipate the unlikely events, and even if we can foresee the events, it can be quite inefficient to prepare for all of them.
How about this?
Yes, by splitting the eggs into 3 baskets, RJ could save two thirds of his eggs even after bumping into a person.
Again, RJ did not expect the accident, but by dividing the risk into 3 parts in the first place, he could reduce his loss.
This example illustrates the effect of diversification and the importance of it. By diversifying the risks that you are taking in investments, you can reduce the impact of an unexpected event on your whole portfolio.
The risks that can be reduced by diversification are called Diversifiable Risks, Unsystematic Risks or Non-systematic risks. Business Risk, Financial Risk and Operational Risk fit under this category. Most of these are company specific or industry specific risks in certain areas.
However, not all risks can be reduced through diversification. Let’s re-visit our eggs in the basket example here. If RJ gets into a car accident, then regardless of whether he split the eggs into three baskets or not, he would not be able to save any of his eggs.
The risks that cannot be reduced through diversification are called as non-diversifiable risks, Systematic Risks or Market Risks. Interest Rate Risk, Market Risk and Inflationary Risks fit under this category. Compare to diversifiable risks, these non-diversifiable risks are more about the overall economy. The risks of falling returns on your investment portfolio due to weakness in general economy cannot be mitigated by diversification.
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