DIVERSIFICATION OF FIRM-SPECIFIC RISK

In 2002, Enron, a large and once widely respected company, went bankrupt amid accusations of fraud and accounting irregularities. Several of the company’s top executives were prosecuted and ended up going to prison. The saddest part of the story, however, involved thousands of lower-level employees. Not only did they lose their jobs, but many lost their life savings as well. The employees had about two-thirds of their retirement funds in Enron stock, which became worthless. If there is one piece of practical advice that finance offers to risk-averse people, it is this: “Don’t put all your eggs in one basket.” You may have heard this before, but finance has turned this folk wisdom into a science. It goes by the name diversification. The market for insurance is one example of diversification. Imagine a town with homeowners each facing the risk of a house fire. If someone starts an insurance company and each person in town becomes both a shareholder and a policyholder of the company, they all reduce their risk through diversification. Each person now faces 1/10,000 of the risk of 10,000 possible fires, rather than the entire risk of a single fire in his own home Ten less the entire town catches fire at the same time, the downside that each person faces is much smaller When people use their savings to buy financial assets, they can also reduce risk through diversification A person who buys stock in a company is ‘placing a bet on the future profitability of that company. That bet is often quite risky because fortunes are hard to predict. Microsoft evolved from a start-up by some geeky teenagers to one of the world’s most valuable companies in only a few years; Enron went from one of the world’s most respected companies to an almost worthless one in only a few months Fortunately, a shareholder need not tie his own fortune to that of any single company. Risk can be reduced by placing a large number of small bets, rather than a small number of large ones  .Figure 2 shows how the risk of a portfolio of stocks depends on the number of stocks in the portfolio Risk is measured here with a statistic called the standard deviation, which you may have learned about in a math or statistics class. The standard deviation measures the volatility of a variable-that is, how much the variable is likely to fluctuate. The higher the standard deviation of a portfolio’s return, the rime it is. The figure shows that the risk of a stock portfolio falls substantially as the number of stocks increases For a portfolio with single stock, the standard deviation is 49 percent. Going from 1 stock to 10 stocks eliminates about half the risk. Going from 10 to 20 stocks reduces the risk by another 13 percent: As the number of stocks continues to increase, risk continues to fall, although the reductions in risk after 20 or 30 stocks are small Notice that it is impossible to eliminate all risk by increasing the number of stocks in the portfolio. Diversification can eliminate firm-specific risk- the uncertainty associated with the specific companies But diversification cannot eliminate market risk-the uncertainty associated with the entire economy which affects all companies traded on the stock market. For example, when the economy goes into a recession, cost companies experience falling sales, reduced profit, and low stock returns. Diversification reduces ‘the risk of holding stocks, but it does not eliminate it.

Figure 2 Diversification Reduces Risk

This figure shows how the risk of a portfolio. measured here with a statistic called the standard deviation, depends on the number of stocks in the portfolio. The investor is assumed to put an equal percentage of his portfolio in each of the stocks. Increasing the number of stocks reduces the amount of risk in a stock portfolio. but it does not eliminate it.

Diversification Reduces Risk

Diversification Reduces Risk

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