Diversification and opportunity costs

Overview

Diversification is a technique used by investors to reduce risks by allocating the investments among various financial components, industries, and other categories. It aims to maximize the returns of the business by investing in different areas. The different regions would react differently to a situation, and help in minimizing the risks to the business.

Diversification in risk reduction

Although diversification cannot guarantee to eliminate risks permanently, it helps to contain a threat and reduce its effects. Also, it can be used to achieve long term financial goals with minimal risk factors attached to it. Diversification helps a person in the business to distribute his assets evenly in all his business assets. In this way, the loss of one asset will ensure that other assets are safe. If risks are attached to a stock, the businessman can choose to invest in the stock without risking his remaining capital assets.

There are mainly two types of risks: diversifiable risks and diversifiable risks. Diversifiable risks are an unsystematic type of risk that can be contained by diversifying the risk among various business assets. On the other hand, non-diversifiable risks are the risks that cannot be contained by diversifying. Such risks are naturally occurring risks, for example, the volatile nature of the market in which business is done (Vannoorenberghe, Wang, & Yu, 2016). To obtain maximum investment returns, people in business should be able to diversify his/her assets in various asset classes. In this way, if one level fails, the other ones shall make up for the damages.

Diversification is a means of stability

Investing everything in one industry can be a poor strategy as if the industry is hit by the poor performance of the consumer market, the overall investments might suffer. Typically, diversification takes time to return the initial investment, but doing so makes the investment portfolio more stable (Kim et al., 2018). Also, it will yield long term earnings, and the portfolio will be able to withstand the fluctuating market. The total wealth should be spread across various industries but should be limited to a certain number. Too much diversification and distribution of assets

Opportunity costs

Opportunity costs are the costs that an investor or a businessman probably miss out when choosing between two options and is less than the returns obtained by the option selected (Argyres, Mahoney, & Nickerson, 2019). This can be used by business owners to make informed decisions when there are multiple options available. Financial reports generally do not show the opportunity costs of a business.

How to measure opportunity costs?

The following formula can measure the opportunity costs on capital:

ROI = market value – cost/cost

The opportunity costs are generally expressed in percentages. The person investing should know what to expect ion the variability of returns of the investments during the period in which the capital is expected to be used up by the investment. The variability of the returns should also be considered while making investments. This variability might get negative during the cash utilization period. By assigning a probability of occurrence to a different return on investments, this variability can be quantified.

References:

Argyres, N., Mahoney, J. T., & Nickerson, J. (2019). Strategic responses to shocks: Comparative adjustment costs, transaction costs, and opportunity costs. Strategic Management Journal, 40(3), 357-376.

Kim, W., Kim, Y. M., Kim, T. H., & Bang, S. (2018). Multi-dimensional portfolio risk and its diversification: A note. Global Finance Journal, 35, 147-156.

Vannoorenberghe, G., Wang, Z., & Yu, Z. (2016). Volatility and diversification of exports: Firm-level theory and evidence. European Economic Review, 89, 216-247.