Question 1: Suppose you have some money. Is it safer to put your money into one business or investment, or to put your money into multiple businesses or investments?
‘The financial concept of diversification’ sounds terrible complicated.
But it’s actually just the reduction of a business-risk.
Let’s say, I give you an order to transport 5 very precious and fragile items from a warehouse across Bucharest to my home. I have a big TIR with space for all 5 items and a smaller transporter with room for 1 item ready for you at the warehouse.
For each item you deliver undamaged, I pay you 1000 EUR; for each item you damage on the transport you won’t get any money, instead you have to pay me 500 EUR for restauration.
Now, the best scenario is, you take the TIR, deliver the items undamaged, cash in 5000 EUR and la revedere.
On the other hand, you risk an accident or gropi will harm all 5 items during transportation and then you owe me 2500 EUR.
This is a pretty shitty risk/reward ratio.
You now start to think how to reduce the risk and come up with the conclusion, to take the smaller vehicle and make the journey 5 times.
You just made a diversification.
With the smaller car, your risk/reward ratio is much better: You maintain the chance to earn 5000 EUR – you just need a little more time.
On the risk side, the probability of an accident has risen since you drive 5 times through Bucharest with an item. But even if you produce on these five roundtrips a highly improbable number of 3 accidents the same day, you still make a profit of minimum 500 EUR. Chances are, that you have at least 1 of these 3 accidents on a retour-to-the-warehouse-trip when the transporter is empty and your profit would rise to 2000 EUR.
The concept of diversification is also very common on financial markets, where investors spread their money over different asset classes like stocks, bonds or money market.
And diversification occurs into a single asset class like stocks through a mix of shares from several countries, sectors, large or small caps.
The founder of this concept, Harry M. Markowitz, was awarded for his portfolio-theory with the Noble Prize in Economics in 1990.
Next topic: question 2 (Inflation) http://www.theleader.ro/inflation-2/