Question

On a recent trip home, your grandfather tells you that he has purchased the stock of two firms in the automobile industry: Toyota and Ford. He goes on to discuss the merits of his decision and one of the points he makes is that he has avoided the risk of purchasing only one company’s stock by diversifying his holdings across two stocks. What do you think of his argument? Based on your study of financial management explain to your grandfather what you have learned about portfolio diversification and how the process of diversification might affect systematic vs. unsystematic risk.

Answer 1

Systematic Risk/ Market Risk refers to the risk that is out of control of an investor and is applicable to the entire market and all its players overall. This risk can never be mitigated completely by an investor. Few examples of systematic risk includes change in government regulations, wars, recessions etc.

Unsystematic risk refers to the risks unique to a particular Company or stock and this can be mitigated by an investor with the help of diversification, i.e, including more than one stock in his portfolio. This way, the investor is not putting all his eggs into one basket. That way, even if one stock is not performing well or is in losses, there is a possibility that the other stocks will be in profits and hence compensate the investor for the loss incurred on one stock. In this light, the investment decision made by my grandfather is quite feasible.

An investor can take maximum benefit of diversification by investing in stocks that are :

1. from different indsutries

2. of different investment horizons

3. most importantly, the stocks should be as negatively correlated as possible, which means that when value of 1 stock falls, the value of the other will rise. As a result, the losses from one stock will be compensated by profits from the other.