Question

Sammy buys stock in a suntan-lotion maker and also stock in an umbrella maker. One stock does well when the weather is good; the other does well when the weather is bad. Sammy's portfolio indicates that “weather risk” is a _______ risk. a. Diversifiable. b. Nondiversifiable. c. Automatic.

Short answer

Weather risk is a diversifiable risk.

Step-by-step solution

Identify the Terms

First, let's identify the different types of risk. Diversifiable risk is specific to a particular company or industry and can be reduced by diversification across different sectors or securities. Nondiversifiable risk, or systematic risk, affects the entire market and cannot be mitigated by diversification. Automatic risk isn't a commonly used term in financial contexts.

Assess Sammy's Portfolio

Sammy holds stocks in two companies affected differently by weather. This means he is spreading his investment across different industries that will not be affected by the same type of weather in the same way.

Determine Risk Type

Since Sammy's portfolio balances the effects of good and bad weather on different stocks, the risks associated with weather can be mitigated (i.e., they do not impact the market evenly). Hence, these risks are diversifiable.

Key concepts

Investment Diversification

Investment diversification is a fundamental strategy in portfolio management. It involves spreading investments across various financial assets, industries, or geographical areas to reduce risk. The idea is simple: don't put all your eggs in one basket.
This means that if one investment performs poorly due to specific factors, the overall impact on the portfolio is minimized because other investments may perform better.
By investing in a range of assets, such as stocks from different industries, you can protect your portfolio from the adverse effects associated with investing in a single sector.

• Diversification helps absorb volatility by spreading risk.
• It allows investors to avoid catastrophic loss.
• Offers potential for higher returns from a mix of asset performance.

Sammy's investment in both a suntan-lotion maker and an umbrella maker is an example of diversification. While one investment may suffer from certain weather conditions, the other may benefit, balancing overall returns.

Systematic Risk

Systematic risk, also known as market risk, affects an entire market or sector, and isn't tied to any specific investment.
Factors contributing to systematic risk can include economic recessions, inflation, political instability, interest rate changes, or natural disasters. These are broad socio-economic factors that a single investor cannot control.

• Systematic risk cannot be diversified away.
• It impacts the entire financial market.
• Investors can manage it through careful allocation across different asset classes.

Even though Sammy diversified his portfolio by investing in different industries, systemic risks like an economic downturn would still impact all his investments. That's why it's important to understand that while diversification can mitigate certain risks, it cannot eliminate risks that affect the market as a whole.

Portfolio Management

Portfolio management refers to the art and science of making decisions about investment mix and policy to match investments with objectives.
It involves evaluating the strengths, weaknesses, opportunities, and threats of each investment, while continuously monitoring their performance.
Key components of portfolio management include asset allocation, investment selection, and performance monitoring.

• Asset Allocation: The process of deciding how to distribute investments among different asset categories, such as stocks, bonds, and cash, in order to achieve a desired risk level.
• Investment Selection: Choosing which specific assets to include in a portfolio.
• Performance Monitoring: Keeping track of an investment's performance and market changes, adjusting the portfolio as necessary.

Through effective portfolio management, investors like Sammy can better achieve their financial goals, balancing risk against potential rewards. It's all about strategic planning and ongoing assessment to maintain a healthy and diversified investment portfolio.