please provide the response in 50 to 75 words for the below two posts.
Diversification refers to a strategy for managing investment risks by allocating money among various financial assets. It is a risk reduction technique that minimizes certain types of risks associated with investments. Businesses often use the diversification strategy to manage risks by potential threats during economic slumps. According to Royal (2020), diversification can potentially improve potential returns and sustain outcomes. Diversification reduces the risk for an investor by spreading risk across different types of investments, intending to increase the likelihood of achieving success in investments.
When an investor puts a high percentage of the portfolio in a single type of investment, they risk total loss if the investment goes wrong. Through diversification of the portfolio, investors can reduce the consequences of having wrong forecasts (Bragg, 2019). When investing in the stock market, it is highly recommended that an investor aims for a diversified portfolio. Besides, considering how the market moves, a diversified portfolio helps distribute financial risks across different financial instruments to maintain balance.
The opportunity cost of capital refers to the incremental or expected return on investment foregone by a business to invest in a better alternative. The goal is to invest in a project that yields the highest returns on investment (Bragg, 2019). It is often measured by comparing the return on investment on two different projects. It is, therefore, often used by investors to make investment decisions.
In the opportunity cost of capital concept, an investor must estimate the variability of returns on the alternative investments through the period, which the capital is expected to be used (Bragg, 2019). If a company is looking at a project with average risk, it implies that the project has the same risk as an ordinary share of common stock. The opportunity cost of capital for such a project is measured by estimating the expected return on the current market by adding the expected risk premium to the current interest rate.
The opportunity cost of capital and diversification in corporate finance are normally discussed in the framework of project risk (Brealey, Myers, Markus, 2019). When making a decision to invest in a particular project, there is always an opportunity cost to it, reflected in the rate of return that the investor could receive with securities that have the same risk as the project of interest. Therefore, to understand how much is given up in terms of investing alternatives, it is important to look at equally risky potential investments, based on historical data on security returns and other factors relevant in today’s market.
In terms of the historical data, it would be overwhelming and time consuming to look at every available stock, which is why analysts tend to rely on market indexes that divide securities into classes which have returns on select stocks combined (Brealey, Myers, Markus, 2019). A good example here would be the Standard & Poor’s Composite Index, largely referenced as S & P 500, which tracks 500 major companies, with its portfolio holding shares in proportion to the actual number of shares issued by each company. Thus, the S & P 500 gives an average portfolio performance based on the 500 tracked firms. In addition to that, there are more niche indexes with the stocks of small companies, international indexes, while some organizations have also created world indexes (Brealey, Myers, Markus, 2019). This abundance of financial data can help in understanding and gauging overall performance of various investments, including U.S. Treasury bills, Treasury bonds, and a portfolio of common stocks, which is relevant in the context of discussing the opportunity cost of capital. Now, historically, Treasury bills have been considered as a very safe investment due to relatively short maturity and a smaller uncertainly associated with the securities when compared to common stocks (Brealey, Myers, Markus, 2019). That said, while common stocks have higher risk, historically there has been a market risk premium (extra return on riskier assets) associated with holding them. As an investor, one will have to weigh the higher return on riskier assets (common stock) against low-risk assets with lesser gains (i.e. Treasury bills).
In cases of average-risk projects, when shareholders compare the return on a company’s project to a diversified portfolio of U.S. stocks, the firm’s financial managers would need to at least match the return on the alternative (Kenton, 2020). A way to identify the project’s cost of capital here is to look at average return on the market portfolio in the past. The tricky part is that calculating the expected return can’t be done by simply relying on common stock performance in the past, as investor aspirations and demands change over time, once again mostly depending on the risk factor (Brealey, Myers, Markus, 2019). A better process implies taking interest rate on Treasury bills plus risk premium which reflects compensation for waiting and the risk – to get the expected return rate for the market portfolio. In my understanding, it is still uncertain whether the estimated risk premium truly reflects investor expectations, as the value would still be based on average risk premium in the past. In addition to that, research indicates that the estimates of risk premium vary significantly across companies , with not much consensus on when to update the estimates (Jacobs & Shivdasani, 2012).
The concept of diversification connects well to the discussion about estimating the return on the market portfolio. Indeed, in this case, an analyst would be calculating the average value across various common stocks, keeping in mind that individual stocks vary in return and risk, with some offering a much higher or much lower risk compared to the average. Here, diversification explains the difference – variability in return across the portfolio of stocks can be reduced by combining returns that aren’t changing in the same direction when market conditions affect business. It makes sense, as such negative correlation allows the investments to balance each other out, without skewing too much towards either aggressive peaking or falling when market conditions shift.
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