Question

From chapter 8, please describe and discuss the concept of risk and diversification, and ensure you include a discussion on dispersion risk and systemic risk.

Book title is higgins Analysis for financial management 12th edition

Answer 1

Individual investors approach the markets from a very different perspective from institutions. Due to the size of an individual investor’s asset pool, he or she may not be able to tolerate short-term fluctuations in the stock market. One way to address this issue is through diversification.

Diversification is a means of managing risk, and it is accomplished by mixing a variety of financial instruments within a single portfolio. The goal of diversification is to minimize the impact that the performance of any one security will have on the overall performance of the whole portfolio. As such, diversification lowers the risk associated with the portfolio.

Here are the three main practices which can help to ensure optimal diversification of a portfolio:

1. Divide your portfolio among multiple investment vehicles, such as cash, stocks, bonds, mutual funds, and more.

2. Vary the level of risk in the securities in which you invest. Pick investments with varied risk levels. This will help to ensure that large losses are offset by gains in other areas.

3. Vary your securities according to industry. This helps to reduce the impact of risks that are industry-specific.

There is perhaps no single greater factor in helping an individual reach his or her long-term financial goals while minimizing risk than diversification. Still, though, diversification is not a fail-proof guarantee against loss. Virtually any investment takes on a certain degree of risk, regardless of how much diversification you employ.

Systemic risk: It is the possibility that an event at the company level could trigger severe instability or collapse an entire industry or economy. Systemic risk was a major contributor to the financial crisis of 2008. Companies considered to be a systemic risk are called "too big to fail." These institutions are large relative to their respective industries or make up a significant part of the overall economy. A company highly interconnected with others is also a source of systemic risk.

Dispersion Risk: Dispersion is a statistical term that describes the size of the range of values expected for a particular variable. In finance, dispersion risk is used in studying the effects of investor and analyst beliefs on securities trading, and in the study of the variability of returns from a particular trading strategy or investment portfolio. It is often interpreted as a measure of the degree of uncertainty and, thus, risk, associated with a particular security or investment portfolio.

For example, the familiar risk measurement, beta, measures the dispersion risk of a security's returns relative to a particular benchmark or market index. If the dispersion is greater than that of the benchmark, then the security is thought to be riskier than the benchmark. If the dispersion is less, then it is thought to be less risky than the benchmark.

A beta measure of 1.0 indicates the investment moves in unison with the benchmark. A beta of 0 signifies no correlation, and a beta less than 0 shows contrary movement to the benchmark. For example, if an investment portfolio has a beta of 1.0 using the S&P 500 as a benchmark, the movement between the portfolio and benchmark is nearly identical. If the S&P 500 is up 10%, so is the portfolio. On a negative beta, if the S&P 500 is up, the portfolio moves in the exact opposite direction, which in this case will move down.

Standard deviation is another commonly used statistic for measuring dispersion. It is a simple way to measure an investment or portfolio's volatility. The lower the standard deviation, the lower the volatility. For example, a biotech stock has a standard deviation of 20.0% with an average return of 10%. An investor should expect the price of the investment to move 20% in either a positive or negative manner away from the average return. In theory, the stock can fluctuate in value from negative 10% to positive 30%. Stocks have the highest standard deviation, with bonds and cash having much lower measures.