Diversification is the best protection investors have from the risks of capital investment. Modern portfolio theory requires that investors diversify their holdings by investing in firms or assets whose financial returns are influenced by different factors. That has traditionally meant investing in firms in different industries. The object is to identify the factors that could cause a firm’s return to vary from what is expected and to invest in firms that differ with regard to those elements of risk. By employing this investment strategy, investors can “diversify away” firm-specific risks.
To further explain the concept of diversification, let us assume that Milton and Cross is in the business of real estate development and had invested all its capital in the development of real estate assets during the period preceding the global financial crisis in the hope that the investment would produce substantial profits, as was the case at that time. It consequently follows that the financial crisis would have caused Milton and Cross to suffer immense loss (or even enter insolvency!).
However, let us assume that Milton and Cross had divided up its investment portfolio, investing 50% of its capital in real estate, 25% in the stock of highly profitable pharmaceutical companies, 15% in 91-day Treasury Bills and 10% in a high yield mutual fund. In this situation Milton and Cross would suffer less negative impact in the event of any economic shock affecting the Real estate sector. The company may lose some money, but it would still be able to hold off the Grim Reaper for a while.
We have often been advised to avoid placing all our eggs in one basket. The best course of action would be to invest in creating another basket and placing some eggs in there, thus preventing you from losing all your eggs in the event that something happens to the first basket.
Milton and Cross Commercial Solicitors provides due diligence and advisory services to individuals, companies and unincorporated organizations desirous of creating, changing or effectively implementing their diversification strategies. We may be contacted by telephone on +2348036258312 or by email at email@example.com.
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