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Naren Work:
Diversification and Opportunity Cost
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 is 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 aim 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.
References
Bragg, S. (2019). Opportunity cost of capital — Accounting Tools. AccountingTools. https://www.accountingtools.com/articles/opportunity-cost-of-capital-definition-and-usage.html.
Royal, J. (2020). Diversification In Investing: Here’s Why It’s So Important For Your Money | Bankrate. https://www.google.com/amp/s/www.bankrate.com/investing/diversification-is-important-in-investing/amp/.
Charnjeet Work:
Diversification is the strategy used by the business as well as investors to mitigate the amount of risk involved. It is also meant that businesses enlarging into numerous locations or differentiating their product range or the areas of operation (Cheng, 2020). It is the risk management strategy used by businesses and investors. It ensures growth in market capitalization.
From the investor’s perspective, diversification refers to the segmentation of the investment in multiple projects, instead of incurring loss by investing in a single project. This assists the investor in mitigating the vulnerabilities. The strategy of the diversification assists the investors to reduce the amount of risk by diversifying the investments in various financial instruments (Cheng, 2020). Also, it helps in increasing the returns on investment. Some investors can also find this diversification is complicated and costlier.
The increase in the return on investment by the business sacrificing an element is called the opportunity cost of capital. The business has several alternatives that it has to choose, the opportunity cost is the portion of the profit that business losses for selecting an option over another. This cost can be computed by considering the return on investments. For example, an investment of $10,000 into a particular project is made, where the opportunity cost is the variation between the project earned and the estimated project earnings.
The project is held idle or suitable if its discounted net present value (NPV) is more than the estimated expenses of financing (Cees, 2020). The project that has higher vulnerability requires a larger discount rate and is vice-versa in the case of low-risk projects. The company
The opportunity cost is computed by considering the interest rates in case of safe capital investment, whereas the project that has the amount of average risk, the estimated rate on returns on the risky project is the opportunity cost that the company takes into consideration.
References
Zhang, Yi-Cheng. (2020). Diversification. 10.1093/oso/9780198840985.003.0005.https://www.researchgate.net/publication/339382019_Diversification/citation/download
Vluggen, Rob & Kuijpers, Relus & Semeijn, Janjaap & Gelderman, Cees. (2020). Social return on investment in the public sector. Journal of Public Procurement. ahead-of-print. 10.1108/JOPP-06-2018-0023.https://www.researchgate.net/publication/340824782_Social_return_on_investment_in_the_
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