Risk and Diversification - Online Tutor, Practice Problems & Exam Prep

Diversification reduces investment risk by spreading capital across various assets, mitigating firm-specific risks while market risks, like recessions, remain unavoidable. The efficient market hypothesis suggests stock prices reflect all available information, making them unpredictable. Investors often act irrationally, leading to market bubbles driven by speculation. Understanding these concepts is crucial for making informed investment decisions and achieving higher returns than risk-free alternatives, such as U.S. Treasury bills. The rate of return is calculated as income divided by the investment price, highlighting the importance of evaluating potential gains against risks.

Market Risk and Firm-specific Risk

So let's go into a little more detail about diversification and the types of risk that we see in the market. So we've talked about risk a little bit, right? And that all has to do with uncertainty. Uncertainty in the market and that's uncertainty regarding the future, right? We don't know whether we're going to make or lose money. So we're taking on risk when we buy an investment. So we talk about diversification as well, right? How do we get rid of risk? It is through diversification. So we're reducing risk. We don't get rid of it entirely, we reduce risk by replacing a single large risk. Let's say buying a whole bunch of money in one company, you know, you buy all like 10,000 stock in one company. Well, what if you bought 10 pieces of stock in 1,000 different companies instead, right? You're going to take smaller, unrelated risks that is diversification. So that's the idea.

How do we diversify? Diversify is to hold a large number of different investments rather than just one investment because if that one investment tanks, you're screwed, right? But if you hold a bunch of different investments, if one of them tanks, well, that wasn't all your money, right? Other ones will go up, things like that. So when we talk about risks that only affect, guess what? One firm. It's specific to that firm. So what would be an example of a firm-specific risk? It might be things with their customer base, their competitors, right? Things that affect that firm specifically. So those would be firm-specific risks. And those types of risks, well, they can be diversified. You can diversify away from specific risk by buying a bunch of different firms that have different firm-specific risks and sometimes even opposite firm-specific risks that offset each other, okay?

So those risks that affect only one firm, you can diversify them. Compare that to market risk and this is a risk that affects the whole market. So a very simple example would be something like a recession. So if there's a recession or maybe let's add like a war, you know, if the country goes to war, some act of terrorism, something that affects the entire market. Well, you can't really diversify that away because everything's going to drop in that situation, right? During a recession, we kinda see everything start to fall so you cannot diversify market risk.

So, that's the risk that's left over, right? You can't diversify the market risk, but you can get rid of that firm-specific risk. So overall, you have less risk, right? Think about someone that just owns one company, right? They just have all of their eggs in one basket. They have firm-specific risk and market risk. The market crashes and the customers leave that market for another company, well, that company is screwed and it's double screwed because of the market risk as well. But if you own a bunch of little things in different companies, that would be diversifying your investments.

So why invest in a piece of stock rather than just putting money in the bank? Well, it's because you're expecting a higher rate of return, right? Let's say you go to the bank and you're offered 1% interest if you're lucky these days, right? You might buy a stock because you think you can make 5%, 10% on your money, right? That would be the risk you're taking to earn a higher return. So when we talk about the risk of an investment, we have to compare it to a risk-free investment, right? Because if we're going to take on some risk, it's got to pay higher than a risk-free investment, right?

A risk-free investment is the return on an investment that has no risk, okay? So a simple idea would be just putting money in a bank account, but generally, when we talk about a risk-free investment, the common thing that we think about is U.S. Treasury bills, okay? Bills or notes, anything that the treasury sells is generally considered to be very low risk or risk-free, okay? Because that would be the idea of the U.S. government collapsing and then those bonds would fail, right? Those investments would fail. But other than that, you're safely expecting to get that money back. So whatever those investments are paying, well, you better make more than that if you're going to take on risk, right? Because why take on any risk if you could just buy the risk-free investment to make the same amount of money? You might as well take the risk-free investment.

So, in the case that you're going to the stock market to buy stock, you should expect to make more money than the risk-free investment. We calculate the rate of return very simply. A rate of return is just the income, the money that you make divided by the price, and generally, when we think about income, it's either going to be dividends, capital gains. In the case of stock, we would have dividends and capital gains. That would be in the case of stock, or in the case of like a bond, we would have interest. You would earn interest, that would be in the case of bonds. Okay. So that's the income that you make. Let me get out of the way so you see that. Over the price, the price you paid, what you paid for the investment. So what you made divided by the take a pause and we'll talk about one more thing related to risk and diversification.

Efficient Markets Theory, Random Walk, and Irrational Behavior

So when you go to buy a piece of stock on the market, a share of stock, how do you know that the price is correct? Well, you don't really, but what we have is the efficient market hypothesis, and this is the idea that the price that we see on the market is taking in all available information about its value. It's hard to talk and write at the same time. All publicly available information is going into that value. So, when you see a share of stock and it's worth $50 that's because all the news reports, all the financial statements that have come out, people have made valuations and they expect it to be worth $50. Now, is that true or not? Well, let's go on a little bit more about this theory. First of all, under this hypothesis, the markets are said to exhibit informational efficiency because all information is reflecting in the price, right? It's efficient with the information that's available is getting into the price. And what we see is that stock prices change when new information becomes available. That's why you see analysts readily waiting for reports to come out, for stockholders meeting where the company is going to tell about the future plans of the company and what they are expecting to do, well, that's going to affect the stock price because it's new available information. And now for that information to be new, well, naturally it must be unpredictable, right? If you could predict what that information was, well then it wouldn't be new, it would have already been included in this available information if you could predict it, right? So that's the whole key here with the efficient market hypothesis is that these investments are going to be unpredictable and therefore, follow a random walk. So when we think about, when we see a stock price, when you look at a stock graph, it looks like this, right? It's just like someone's crazy heart chart that's having some sort of spasm in their heart. That's what the chart looks like, right? And it's a variable that it's impossible to predict. So people who try and say, oh, this stock has been going up in price. So naturally, it's going to continue to go or they look at historical data to gauge what's going to happen in the future. You can't really do that with stocks, because that's the whole idea with this hypothesis is that that random walk, that path that it's been taking, is basically dealing with this change in information. However, when we think about this Efficient Market hypothesis, it's not taking into account one thing. Are people completely rational when they invest in the market? Think about all these bubbles that we've had. There's all sorts of bubbles in the real estate market. The real estate market in the Great Recession of 2008 kept rising, and people would keep buying houses and selling houses and they were just trying to make a quick buck because of all of the gains in the real estate market or the dotcom bubble of the late 1990s, right? Where the people were just buying any website just because it had a dotcom after it, they knew it was going to make money, so they would buy in and just hope to get out before anyone else does, right? So this idea of speculation, people are just speculating. They're basically gambling that these things are going to go up in value. Well, that's going to affect the price as well, right? If a lot of people are just buying things just because everyone else is buying it, right? Everyone else is buying real estate. I want to make money too. It's this idea of FOMO, right? The fear of missing out, they want to make that money too. Everyone else is making money. I want to make money too. So that's going to inflate the price and eventually, that bubble will pop, and a lot of people will lose the money. Everyone who's still holding it will lose, lose out in the end. Cool? So that's the idea of this efficient market theory and how it doesn't totally work out because people aren't always completely rational and sometimes are just focused on making that short-term quick buck. All right, let's take a pause here and let's move on to the next.

Here’s what students ask on this topic:

What is diversification in investment and how does it reduce risk?

Diversification in investment involves spreading your capital across various assets to mitigate risk. Instead of investing all your money in a single company, you invest in multiple companies or asset types. This strategy reduces firm-specific risk, which is the risk associated with a particular company, such as changes in its customer base or competition. By holding a diversified portfolio, if one investment performs poorly, the impact on your overall portfolio is minimized because other investments may perform well. However, diversification cannot eliminate market risk, which affects all investments, such as during a recession or war.

What is the efficient market hypothesis and how does it relate to stock prices?

The efficient market hypothesis (EMH) posits that stock prices reflect all available information. According to EMH, markets exhibit informational efficiency, meaning that all publicly available information is already factored into stock prices. As new information becomes available, stock prices adjust accordingly. This makes predicting stock prices difficult, as they follow a random walk. However, EMH does not account for irrational investor behavior, such as speculation and market bubbles, where prices can be driven by emotions and herd mentality rather than fundamental values.

What are firm-specific risks and how can they be diversified?

Firm-specific risks are risks that affect only a particular company, such as changes in its customer base, management issues, or competition. These risks can be diversified by investing in a variety of companies with different firm-specific risks. By holding a diversified portfolio, the negative impact of one company's poor performance can be offset by the positive performance of other companies. This reduces the overall risk of the investment portfolio, although it does not eliminate market risk, which affects all companies.

How is the rate of return on an investment calculated?

The rate of return on an investment is calculated by dividing the income generated by the investment by the price paid for the investment. The formula is:

$\frac{\mathrm{Income}}{\mathrm{Price}}$

For stocks, income can include dividends and capital gains, while for bonds, it includes interest payments. This calculation helps investors evaluate the potential gains against the risks of the investment, ensuring that the expected return is higher than that of a risk-free investment, such as U.S. Treasury bills.

What is market risk and why can't it be diversified away?

Market risk, also known as systematic risk, is the risk that affects the entire market or a large segment of it. Examples include recessions, wars, and acts of terrorism. Unlike firm-specific risk, market risk cannot be diversified away because it impacts all investments simultaneously. Diversification can reduce firm-specific risk by spreading investments across various assets, but it cannot eliminate market risk. Investors must accept market risk as an inherent part of investing in the market.