WHAT IS DIVERSIFICATION?
PROS AND CONS OF FINANCIAL RISK
Risk is the opposite side of reward. Financial risk is an uncertain situation. It exists in varying degrees. The term ‘risk’ has a negative implication, and financial risk can spread from one firm to another or across sectors/markets/worldwide, making things even more serious. Therefore, understanding and assessing the financial risks associated with assets can lead to better and more informed business decisions. Another term, specific risk, is used when only one or more companies suffer financially. This type of risk associated with a company or group of companies affects its capital structure, credit risk, and Dubai Financial Market transactions. Certain risks, therefore, reflect the investor’s uncertainty regarding the achievement of returns and possible losses.
In addition, businesses are also exposed to operational risks. This type of risk management exists when a company needs better financial justification or controls. They need to improve their efforts due to internal factors. Financial risks affect businesses of all shapes and sizes. Therefore, awareness of financial risks is essential. However, knowing the dangers and strategies to protect yourself does not eliminate the risks. Instead, it mitigates damage and reduces the potential for adverse effects.
There are significant differences in how different industries and sectors operate. Therefore, diversifying investors across different industries makes them less susceptible to industry-specific risks.
For example, consider the CHIPS and Science Act of 2022.
The law will affect various industries, but some businesses will be affected more than others. For example, semiconductor makers will be hit hard, while the financial services sector will be less affected and likely to remain.
Investors can diversify across industries by combining investments that can offset different companies. For example, consider two primary means of entertainment.
Travel and digital streaming. Investors who want to avoid the risk of major impacts from future pandemics can invest in digital streaming platforms (i.e., platforms positively impacted by shutdowns). At the same time, investors can consider investing in airlines (positive impact of fewer closures). These two independent industries can minimize the overall risk of your portfolio.
COMPANY LIFE CYCLE PHASES (GROWTH VS. WORTH)
PUBLICLY TRADED STOCKS ARE GENERALLY DIVIDED INTO TWO CATEGORIES:
Growth or value stocks. Growth stocks are companies expected to grow earnings or sales above the industry average. Value stocks trade at a discount based on the company’s current fundamentals.
Growth stocks tend to be riskier as the company’s expected growth may not materialize. For example, when the Federal Reserve tightens monetary policy, it typically results in less available capital (or higher borrowing costs), creating a tougher scenario for growth companies. But growth companies can unlock the seemingly limitless potential to exceed expectations and generate higher returns than expected.
Value stocks, on the other hand, are more established and stable companies. As a result, even if these companies have already realized most of their potential, they are usually less risky. By diversifying into both, investors are taking advantage of the future potential of some companies while recognizing the existing advantages of others.
MARKET CAPITALIZATION (BIG VS. SMALL)
Investors should consider investing in various securities based on the underlying market capitalization of the assets or company. Consider the significant operational differences between Apple and Embecta Corporation. As of August 2022, both companies are included in the S&P 500, with Apple at 7.3% of the index and Embecta at 0.000005% of them.
The two companies take very different approaches to raise capital, bringing new products to market, and increasing brand awareness and growth potential. As a result, small-cap stocks have room to grow, while large-cap stocks tend to be safer investments.
Almost all asset classes allow investors to choose the potential risk profile of security. For example, consider fixed-income securities. Investors can buy bonds from the world’s highest-rated governments or nearly defunct private companies to raise emergency funds. However, significant differences exist between some 10-year bonds based on issuer, credit rating, future operating prospects, and existing debt.
The same applies to other types of investments. For example, riskier real estate development projects can yield greater returns than existing operating properties. On the other hand, a long-established and widely accepted cryptocurrency like Bitcoin is less risky than coins and tokens with a smaller market capitalization.
Different maturities affect different risk profiles for fixed-income securities such as bonds. Generally, the longer the term, the higher the risk of bond price volatility due to changes in interest rates. On the other hand, short-term bonds tend to offer lower interest rates. However, they are also less susceptible to future yield curve uncertainty. Therefore, a risk-conscious investor may consider adding longer-term bonds with higher interest rates.
Maturity is also widely used in other asset classes. For example, consider the difference between a short-term residential lease (meaning up to a year) and a long-term commercial lease (meaning five years or more in some cases). Long-term contracts offer more reliable rental income, but investors sacrifice the flexibility to raise rents or change tenants.
PHYSICAL LOCATION (OVERSEAS AND DOMESTIC)
Investors can obtain additional diversification benefits by investing in foreign securities. For example, forces pushing down the US economy may not affect the Japanese economy similarly. Therefore, by owning Japanese stocks, investors can protect themselves from losses in the event of an economic downturn.
Or a Greater upside potential (with an associated higher level of risk) when diversified across developed and emerging markets. For example, Consider Pakistan’s current classification as a frontier market participant (recently downgraded from emerging market participant).
4 Investors willing to take higher risks are advised to consider the high growth potential of a small but fully established market like Pakistan.
Financial instruments such as bonds and stocks are intangible assets. It cannot be physically touched or felt. On the other hand, tangible assets such as land, real estate, agricultural land, precious metals, and goods can be touched and owned. Real-world applications. These tangible assets have different investment profiles as they can be consumed, leased, developed, or handled differently than intangible and digital assets.
There are also risks specific to tangible assets. For example, the property can be destroyed, physically stolen, damaged by natural causes, or aged. Tangible assets may also require storage, insurance, or security costs. Financial instruments have different income streams but have different input costs to protect physical assets.