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Reducing risk through diversification

Reducing risk through diversification

From the course: Finance Foundations

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Reducing risk through diversification

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We don't like risk, we have to be paid to bear risk. But some risk can be reduced through diversification. Diversification is just a fancy way of saying don't put all your eggs in one basket. If you put all your eggs in one basket and you trip, you've ruined all your eggs. But if you spread your eggs around, you've diversified your risk. Now, some risks are avoidable and some risks are unavoidable. For example, think about job risk. If I'm a construction worker, I am working in a risky place, a construction site. Don't expect to be paid extra for bearing risk that can be avoided. You can avoid a lot of risks by wearing a hard hat, so you're not going to get paid extra for not wearing your hard hat. Companies have risks that investors can avoid through diversification. Random bad things happen to companies, random good things happen to companies. One random good thing is that something bad happens to your competitor. Or maybe an ordinary product breaks out. You sell hula hoops, which…

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