3. What about diversification? How can we deal with risk in assets and what is risk anyhow?
Diversification in a recession, Is it effective?
When it comes to investing, the most decisive factor is of course the level of risk associated with decision. Although thought of as a negative determinant, the level of risk will ultimately influence the extent of one’s economic returns- positive or negative. Risk; defined as ‘the chance that an investment's actual return will be different than expected’ (1), has becoming increasingly complex and difficult to manage since the start of the current financial crisis, and investors have employed numerous tactics in an effort to reduce their exposure to risk. Hedging, insuring and diversifying are 3 types of risk management strategies, all of which are effective and necessary especially in the current economic climate.
There are various different types of risk which can affect investments, divided into two categories, unsystematic (diversifiable) and systematic (non-diversifiable). Diversifiable risk is simply risk that is specific to a particular security or sector. It can be minimised by creating a portfolio with a large number of sound investments, all of which have little influence on the rest of the investments held. Take for example a portfolio of 3 airline stocks AMR, BAY and DAL. This portfolio contains a large amount of risk- risk which can be diversified away by the purchase of unrelated stock. If, for instance, the airline market was affected by a terrorist attack, the share prices for airline stock in general would decrease, therefore decreasing the entire value of the portfolio as all of the investments are related to air travel.
What about now though? If ever markets were under-performing, volatile and incredibly risky, it’d be now. With fears of a double-dip recession and continuing low growth rates, will diversification be enough to offset the huge amount of systematic risk associated with market failure? Can investors protect themselves from personal losses by spreading their investments across a wide range of industries? In my opinion, its downturns like these in which diversification demonstrates its effectiveness and ability to prevent significant losses for investors.
Volatility is essential for returns. 100€ placed in a company today could earn thousands tomorrow. Riskier investments generally generate greater returns- and greater losses. For the lucky (or smart) few, huge profits can be made on dangerous, risky investments. This however is not universal and most investors like to minimise their risk and ensure against any losses, losses which are ever prevalent during a recession. Some economists have argued that trying to diversify away risk in a recession is both impossible and useless. They believe that the effects of an underperforming market will cause stock indices to plummet, ultimately reducing the value of any portfolio. They see diversification as a futile attempt to reduce inevitable exposure to the market’s failings.
To me this attitude seems like a losing one, one which surely won’t increase your chance of retaining any sort of value in a portfolio. Booms and busts are part of the economic cycle. The economy will recover, and unfortunately, fall again. But does this mean that there is no one who can weather the storm? Is every business, like every portfolio doomed to periods of financial loss and hardship? The whole concept of diversification is that some of the risk is removed by arranging assets in a manner that not all of them are contingent. Of course, certain industries will be affected, and the sales and share prices of certain companies will fall, but will this necessarily topple your portfolio? Not if you have sufficiently diversified your investments. Many companies have in fact profited from the downturn; either due to the nature of the industry in which they operate, or the fact that their superior positioning has allowed them to benefit from their insolvent competitors.
Amazon.com is one of these companies. They have seen their revenue increase 38% since the beginning of the recession in 2007. (2) The online retailer has seen sales soar as thrifty consumers opt to search online for the best deals rather than buy from retail outlets. The ‘Wall-Mart of the web’ (3) has shown that its online store is both flexible and effective and with a low cost model, Amazon has enjoyed increased profits in recent years. Its share price has increased by 400% since January 2007, demonstrating its strength in the current market and US analysts at Stifel Nicolaus recently upgraded their shares to a buy rating. (4)
Another company which has thrived despite the recession is the world’s largest retailer Wal-Mart. With its focus on low, ultra-competitive prices, Wal-Mart has become the replacement destination to the higher priced competitors. Net Income has risen in the past 3 years; 13.381$ billion in 2009, 14.37$ billion in 2010 and 16.389$ billion in 2011 (5), all while maintaining its philosophy of having the lowest prices around. Similar to Amazon, although not as considerable, Wal-Mart’s share price has risen from around 47$ to just under 60$ (6) over the past 4 years, 4 years in which we have experienced the most severe economic downturn in recent times, proving that not all investments are doomed to fail during a recession.
References:
2) http://articles.moneycentral.msn.com/Investing/FindHotStocks/10-retailers-rising-in-the-recession.aspx
3) http://www.brandchannel.com/home/post/2009/09/22/Nimble-Amazon-Thrives-In- Recession.aspx
4) http://www.reuters.com/article/2011/10/03/us-amazon-research-stifel-idUSTRE7922EK20111003
5) http://moneycentral.msn.com/investor/invsub/results/statemnt.aspx?symbol=wmt
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