Before you start reading the sample, let’s try to understand diversified investing. It is the distribution of investments using various instruments in order to reduce risks and increase profits. For example, a person that wants to keep savings on a bank account may be advised to create three accounts in different currencies or to buy stocks and bonds. Every investment is supported with certain risks, especially in crisis periods. Most often, the higher the risk, the greater the potential profit (or loss). In the following investment essay sample the writer has described the economist’s point of view about diversified investments.
What Do Economists Think About Diversified Investing?
Risk-aversion and rationality are the underlying assumptions to which economists, almost unanimously, agree upon in order to characterize agents dealing with investing. However, they fail to provide an equally unanimous guideline as for managing risk in a portfolio context.
Homo economicous requires a premium in order to bear some degree of uncertainty.
The latter tenet characterizes Modern Portfolio Theory and constitutes the bulk of Harry Markowitz’s vision. According to the Nobel laureate, portfolio combinations lay on the so-called efficient frontier, where the trade-off between risk and return is the driving force.
According to this idea, investors favour stocks that historically counter-moved in the market, preferably across different industries, when structuring their portfolios. The ultimate goal results in reducing the idiosyncratic risk in each individual stock and the choice of an increasing number of assets meeting these criteria leads to diversification.
William Sharpe, who developed the CAPM model coherently with the idea of efficient frontier, justifies diversification as follows:
A balanced portfolio with a diversification of X will have as much non-market risk as a balanced portfolio of X securities, each with a typical amount of non-market risk, and each worth an equal dollar amount at current market prices. The term “balanced” is included to rule out portfolios with heavy concentrations of similar securities. Such portfolios will generally be less diversified than indicated by the calculation described here i.e., they will have more non-market risk (Sharpe 76).
This perspective is not universally shared in Academia, at least for what concerns portfolio composition.
The main critics by the detractors of the diversified approach concern the average returns achievable and the appeal to an ignorant cohort of investors solely.
The contributions hinting to portfolio concentration pertain to, among others, John Maynard Keynes, Charlie Munger and Gerald Loeb. Their perspective, characterizing also Warren Buffet’s investment style, suggests to cherry pick the stocks held in a portfolio. Such a choice relies on the perceived intrinsic value, with a forward-looking approach prevailing. In this context, competency in assessing stocks’ quality is preferred over quantity and variance-covariance measures when coping with portfolio’s risk.
The attitude of Economists towards diversification is non-homogeneous and somewhat contrastive. On the one hand, a school of thought advocates for the “don’t put all your eggs in one basket” concept, while another stream promotes a wise stocks’ picking instead.
The distinction traces back to the visions of two of the most influential authors of the last century: respectively Harry Markowitz and John Maynard Keynes. Drawing from these two pillar contributions, research efforts spread in both directions.
Markowitz, Harry. “Portfolio Selection.” The Journal of Finance, vol. 7, no. 1, Mar. 1992, pp. 77–91. 1, doi:10.2307/2975974.
Sharpe, William F. “Risk, Market Sensitivity and Diversification.” Financial Analysts Journal, vol. 28, no. 1, 1972, pp. 74–79. 1, www.jstor.org/stable/4470889.
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If you hear words like “investment,” “economy,” and “assets” and it makes you cry, it’s probably your great luck that you have found our sample. If you were assigned a similar topic as in our sample, feel free to use it for your inspiration and as an additional source of information. Keep in mind that this investment essay sample was completed according to requirements that may differ from requirements that you have received from your tutor. All copied material without proper acknowledgments may be considered plagiarism, so be sure that you have used the right citation format. If you want to write your economics essay more effectively, read the secrets of writing an essay on economics here.