Aswath Damodaran 68
The Importance of Diversification: Risk Types
Actions/Risk that
afifrfmect only one
Actions/Risk that
affect all investments
Firm-specific Market
dPor objeetcttes^ rm oary
worse than
expected
Competition
may be stronger
oanrt wiceipaakteerd than
Entire Sector
may be affected
by action
Exchange rate
and Political
risk
Interest rate,
Inflation &
neceownso amboyut
Figure 3.5: A Break Down of Risk
Affects few
firms
Affects many
firms
Freirdmuc cea bny Ionfv persotijnegct isn lots (^) cAocmqpueiritintogr (^) s Dacivroesrss isfeycintogr (^) s aDcirvoesrss cifoyiunngt (^) ries Cannot affect
Investors
cmainti (^) gate by
Diversifying across domestic stocks Diversifying across
asset classes
Diversifying globally
This is the critical second step that all risk and return models in finance take.
As examples,
Project-specific Risk: Disney’s new Animal Kingdom theme park: To
the degree that actual revenues at this park may be greater or less than
expected.
Competitive Risk: The competition (Universal Studios, for instance) may
take actions (like opening or closing a park) that affect Disney’s
revenues at Animal Kingdom.
Industry-specific risk: Congress may pass laws affecting cable and
network television, and affect expected revenues at Disney and ABC, as
well as all other firms in the sector, perhaps to varying degrees.
International Risk: As the Asian crisis deepened in the late 1990s, there
wasy be a loss of revenues at Disneyland (as tourists from Asia choose
to stay home) and at Tokyo Disney
Market risk: If interest rates in the US go up, Disney’s value as a firm
will be affected.
From the perspective of an investor who holds only Disney, all risk is relevant.
From the perspective of a diversified investor, the first three risks can be
diversified away, the fourth might be diversifiable (with a globally diversified
portfolio) but the last risk I not.
