Let’s start with a true story. Rambus Inc. has been suing companies in a law suit that has lasted 7 years. Rambus hoped to get $4 billion in damages. Yesterday morning, November 16, 2011, the stock was selling at $18 per share. During the day, the court ruled that Rambus had not been illegally damaged by any party and deserved no compensation whatsoever. By 4pm, the value of Rambus’s stock had fallen to $7.11, a 61% drop in value. The stock price may come back or it may not. That’s not the point. The point is that the investors could well have lost 61% of their money in a matter of seconds. It happens more frequently than one would like to think about.
Here we see the importance of diversification in risk management. Portfolio diversification involves 2 strategies.
First, one should divide ones assets into several different investment vehicles such as stocks, mutual funds, bonds, cash, real estate etc.
The second strategy is similar to the first. Within each investment category divide your assets into different types of investments. For example, one should divide one’s stock investment into perhaps 10 different stocks. These stocks should be from different, unrelated industries to provide further diversification. This protects the investor so that if one stock goes down, the others may remain stable or even go up.
When we view an entire portfolio, we will see that the risk is diversified among various investments and therefore the entire portfolio is safer.
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