The average of all the returns in a diverse portfolio can never exceed that of the top-performing investment, and will almost always be lower than the highest return. This is unavoidable, and is the cost of the risk insurance that diversification provides. However, strategies exist that allow the portfolio’s manager to maximize returns while still keeping risk as low as possible. Although detailed calculations are beyond the scope of this article, these strategies seek to maximize returns by giving different portfolio weights to investments based on their risk and return expectations.
Diversification in finance is a risk management technique, related to hedging, that mixes a wide variety of investments within a portfolio. Because the fluctuations of a single security have less impact on a diverse portfolio, diversification minimizes the risk from any one investment.
A simple example of diversification is the following: On a particular island the entire economy consists of two companies: one that sells umbrellas and another that sells sunscreen. If a portfolio is completely invested in the company that sells umbrellas, it will have strong performance during the rainy season, but poor performance when the weather is sunny. The reverse occurs if the portfolio is only invested in the sunscreen company, the alternative investment: the portfolio will be high performance when the sun is out, but will tank when clouds roll in. To minimize the weather-dependent risk in the example portfolio, the investment should be split between the companies. With this diversified portfolio, returns are decent no matter the weather, rather than alternating between excellent and terrible.
There are three primary strategies used in improving diversification:
Spread the portfolio among multiple investment vehicles, such as stocks, mutual funds, bonds, and cash.
Vary the risk in the securities. A portfolio can also be diversified into different mutual fund investment strategies, including growth funds, balanced funds, index funds, small cap, and large cap funds. When a portfolio includes investments with varied risk levels, large losses in one area are offset by other areas.
Vary your securities by industry, or by geography. This will minimize the impact of industry- or location-specific risks. The example portfolio above was diversified by investing in both umbrellas and sunscreen. Another practical application of this kind of diversification is mixing investments between domestic and international funds. By choosing funds in many countries, events within any one country’s economy have less effect on the overall portfolio.
Although diversification reduces the risk of a portfolio, it does not necessarily reduce the returns. As a result, diversification is referred to as “the only free lunch in finance.” Statistical analysis shows that there may be some validity to this claim.
Appreciation is a term used in accounting relating to the increase in value of an asset. In this sense it is the reverse of depreciation, which measures the fall in value of assets over their normal life-time.
Appreciation is a rise of a currency in a floating exchange rate.
In times of high inflation, appreciation will be common to all balance sheet assets. Generally, the term is reserved for property or, more specifically, land and buildings. In any viable modern economy, such property tends to increase in value over the years – if only because of the scarcity of usable land forces its price in a competitive situation. However, this belief has often caused speculative bubbles to arise.
There are considerable difficulties in assessing the increase in value of any particular asset. This is principally because of the variety of interpretations that can be attached to the word value itself and due to the various instruments and methods used in the valuation process.
The most common form of real estate investment as it includes property purchased as a primary residence. In many cases the buyer does not have the full purchase price for a property and must engage a lender such as a bank, finance company or private lender. Different countries have their individual normal lending levels, but usually they will fall into the range of 70-90% of the purchase price. Against other types of real estate, residential real estate is the least risky.
In real estate, investment money is used to purchase property for the purpose of holding or leasing for income and there is an element of capital risk.
In finance, investment is the buying securities or other monetary or paper (financial) assets in the money markets or capital markets, or in fairly liquid real assets, such as gold, real estate, or collectibles. Valuation is the method for assessing whether a potential investment is worth its price. Returns on investments will follow the risk-return spectrum.
Types of financial investments include shares, other equity investment, and bonds (including bonds denominated in foreign currencies). These financial assets are then expected to provide income or positive future cash flows, and may increase or decrease in value giving the investor capital gains or losses.
Trades in contingent claims or derivative securities do not necessarily have future positive expected cash flows, and so are not considered assets, or strictly speaking, securities or investments. Nevertheless, since their cash flows are closely related to (or derived from) those of specific securities, they are often studied as or treated as investments.
Investments are often made indirectly through intermediaries, such as banks, mutual funds, pension funds, insurance companies, collective investment schemes, and investment clubs. Though their legal and procedural details differ, an intermediary generally makes an investment using money from many individuals, each of whom receives a claim on the intermediary.
A market is the means through which buyers and sellers are brought together to aid in the transfer of goods and/or services. Several aspects of this general definition seem worthy of emphasis. First, a market need not have a physical location. It is only necessary that the buyers and sellers can communicate regarding the relevant aspects of the transaction. Second, the market does not necessarily own the goods or services involved. When we discuss what is required for a good market, you will note that ownership is not involved; the important criterion is the smooth, cheap transfer of goods and services. In most financial markets, those who establish and administer the market do not own the assets. They simply provide a physical location or an electronic system that allows potential buyers and sellers to interact, and they help the market function by providing information and facilities to aid in the transfer of ownership.
Finally, a market can deal in any variety of goods and services. For any commodity or services with a diverse clientele, a market should evolve to aid in the transfer of that commodity or service. Both buyers and sellers will benefit from the existence of a market. Basically, we take markets for granted because they are vital to a smooth-operating economy. Still, it is important to recognize that the quality of alternative markets can differ.
Vertical diversification is investment between different types of securities. Again, it can be a very broad diversification, like diversifying between bonds and stocks, or a more narrowed diversification, like diversifying between stocks of different branches. Continuing the example from the introduction, a vertical diversification would be taking some money from umbrella and sunscreen stock and investing it instead in bonds issued the government of the island.
While horizontal diversification lessens the risk of investing entirely in one security, vertical diversification goes beyond that and protects against market and/or economical changes.
Horizontal diversification is when a portfolio is diversified between same-type investments. It can be a broad diversification (like investing in several NASDAQ companies) or more narrowed (investing in several stocks of the same branch or sector). In the example above, the move to invest in both umbrellas and sunscreen is an example of horizontal diversification. As usual, the broader the diversification the lower the risk from any one investment.
Most generally, the accumulation of capital refers simply to the gathering or amassment of objects of value; the increase in wealth; or the creation of wealth. Capital can be generally defined as assets invested with the expectation that their value will increase, usually because there is the expectation of profit, rent, interest, royalties, capital gain or some other kind of return.
The definition of capital accumulation is subject to controversy and ambiguities, because it could refer to a net addition to existing wealth, or to a redistribution of wealth. If more wealth is produced than there was before, a society becomes richer; the total stock of wealth increases. But if some accumulate capital only at the expense of others, wealth is merely shifted from A to B. In principle, it is possible that a few people or organisations accumulate capital and grow richer, although the total stock of wealth of society decreases. Most often, capital accumulation involves both a net addition and a redistribution of wealth, which may raise the question of who really benefits from it most.
In economics, accounting and Marxian economics, capital accumulation is often equated with investment of profit income, especially in real capital goods. The concentration and centralisation of capital are two of the results of such accumulation (see below).
But capital accumulation can refer variously to
- working and consuming less than earned (saving or accumulating the residual)
- relying on the effects of compound interest to increase initial capital
- real investment in tangible means of production.
- financial investment in assets represented on paper.
- investment in non-productive physical assets such as residential real estate that appreciate in value.
- consuming less than produced by productive assets like farm land–saving or accumulating the residual
- “human capital accumulation,” i.e., new education and training increasing the skills of the (potential) labour force.
Non-financial and financial capital accumulation is usually needed for economic growth, since additional production usually requires additional funds to enlarge the scale of production. Smarter and more productive organization of production can also increase production without increased capital. Capital can be created without increased investment by inventions or improved organization that increase productivity, discoveries of new assets (oil, gold, minerals, etc.), the sale of property, etc.
In modern macroeconomics and econometrics the term capital formation is often used in preference to “accumulation”, though UNCTAD refers nowadays to “accumulation”.