Diversification of risks is one of the main provisions of the economy, the essence of which is the maximum leveling of threats in the process of investment activity, in production, insurance and other areas of entrepreneurial activity. In this material we will dwell on this principle in detail. The main objective of risk diversification in all mentioned sectors of the economy is to prevent bankruptcy, as well as the desire to maximize profits and ensure the safety of capital.
Risk sharing in investing
In this case, we are talking about creating a portfolio of investments with different returns, liquidity and degree of reliability. For its organization, investment instruments of various types are used. It should be noted that when creating such a set of investments it is advisable to include assets related to different business fields. Thus, diversification of financial risks is carried out.
For example, investing money exclusively in stocks and bonds increases the likely risks, since the profitability and reliability of assets in this case directly depends on the situation on exchanges. At the same time, a portfolio that includes, in addition to securities, foreign currency, real estate and precious metals, is subject to less economic threats.
There are assets whose value changes in one direction. In other words, they have a positive correlation. So, the task of diversifying risks in investing is to select investment instruments that have the least degree of mutual dependence. In such cases, a decrease in the value of one instrument creates the likelihood of an increase in the price of another.
Risks in investing
The whole set of investment risks can be divided into specific and market ones. Specific risks are those that depend on the issuer of the securities. All remaining after eliminating the first risks are market ones. An investment portfolio with a sufficiently high level of risk diversification is almost always exposed to market threats. It is impossible to defend oneself entirely from them, but there are ways to minimize their influence.
For example, analytical studies show that a portfolio of 7-10 shares is able to eliminate specific risks by 80%. But a set of 12-18 shares of various organizations ensures the safety of investments from specific risks by 90%. What is this talking about? The fact that competent diversification reduces the risk of losing investment.
Varieties of risks in investing
In addition, there is another classification of investment risks, which we will discuss below. Separate the state and economic risks of a segment, industry or individual company. Government risks are caused by a possible change in the regulatory framework and, accordingly, the climate for doing business. There is a possibility of nationalization of individual enterprises.
One of the main risks in investing are economic threats. They may depend on the relevant situation, global or local financial crises and recessions. The risks of the investment tool segment are threats that are characteristic of the sector of the national economy in which part of the funds was invested. An example is the real estate market in the crisis process, which is fixed by a decrease in the cost of apartments, houses, offices and other objects. Another example is stocks, the price of which may collapse during the stock market crisis. In risk management, diversification of own investments plays a decisive role. Let's look at a few more examples.
The risks of industries are threats that can occur when demand for a product falls. For example, an investor acquired the shares of an oil refinery, and the world value of “black gold” collapsed. In this case, the share price of the purchased company on the exchange will decrease. The risks of an individual organization represent the possibility of bankruptcy, a decrease in production volumes and market share, as well as other crisis phenomena in a single company.
Risk minimization
Consider methods of risk diversification. It is impossible to completely protect your investment portfolio from them. However, minimizing is quite real. For example, government risks are reduced by the method of sharing threats between different countries. Large investment organizations and private investors acquire the assets of foreign enterprises and entire states.
Economic risks can be minimized by investing in assets of different classes. Among experienced investors, it is known that the fall of the stock market is accompanied by an increase in the value of gold and other precious metals. Risks by segments of the economy can be mitigated using a tool such as hedging. Its essence lies in the acquisition of futures of specific fixed-price assets. Thus, the risk of falling stock prices of these assets on other trading floors is eliminated. What other methods of risk diversification exist?
To reduce industry risks, the method of inclusion in the investment portfolio of assets related to various sectors of the economy is used. For example, securities of oil companies can be supplemented with shares of organizations from the financial sector of the economy. Most often, such insurance uses issue documents of the so-called “blue chips” - companies with the highest profitability, liquidity and reliability. To protect the investment portfolio from the risks of bankruptcy of one organization will help investing in several companies in the same industry.
False diversification
Consider another form of risk sharing. False diversification is a common occurrence among inexperienced or novice investors. It is also called "naive." It is characterized by the protection of capital only against certain risks, which does not provide high guarantees for the preservation of the investment portfolio. We give an example. An investor acquires shares in five different oil refining companies. Diversification as such is present, but if world oil prices fall, the value of the shares of these enterprises will decrease. In general, this will make the entire investment portfolio cheaper.
Distribution of risks in production
The principle of risk diversification is also used in production. In this case, we are talking about a set of measures that are aimed at increasing the stability of the company, protecting it from possible bankruptcy, and increasing profits. What are these mechanisms? First of all, we are talking about expanding the production line, launching new production lines and expanding the range of manufactured products. The development of new areas that are not related to each other is a classic example of diversification in production.
Types of production risk distribution
Let us consider in more detail the diversification of production and its types. In enterprises, it can be of two types. The first involves the connection of new lines of business with those already existing in the company. Another type of distribution of risks in production involves the creation of a new product or service that is not related to a product already being produced by the organization. This is lateral diversification.
Vertical and horizontal distribution of risks
A related view is that the company carries out activities at the previous or next stage of the production chain. For example, an equipment-producing organization begins to independently manufacture component parts for its devices. Thus, the company diversifies down the chain. You can give another example, when the enterprise, producing microprocessors, begins to independently assemble ready-to-use personal computers. In this case, we illustrated the model, the so-called vertical diversification. But along with it another type is used.
Horizontal diversification is the organization's production of related products. For example, a company specializing in the production of televisions launches a line for the manufacture of telephones. Moreover, this product can be presented on the market under a new brand or under an existing one.
Diversification of risks in insurance
Risk sharing is also actively used in the insurance business. In this sector of the economy there are tools specific for this particular area of entrepreneurial activity. First of all, we are talking about a mechanism for transferring risks related to the assets of the insurer or its obligations. We list the most common. The methods of redistributing risks in insurance inherent in the assets of the insurer include the expansion of the totality of assets and the use of various financial instruments. The methods of risk diversification related to liabilities include reinsurance and securitization of insurance liability.