 Hello and welcome to the session. This is Professor Farhad in which we would look at the idea of the diversification and portfolio risk. Specifically, we're going to be covering two concepts that deals with this, which is systematic versus in-systematic risk. These topics are covered on the CPA as well as the CFA exam, as well as essentials or principles of investments. As always, I would like to remind you to connect with me only then if you haven't done so. YouTube is where you would need to subscribe. I have 1,800 plus accounting, auditing, tax, finance, as well as Excel tutorial. If you like my lectures, please like them, share them, put them in playlists. If they benefit you, it means they might benefit other people. Connect with me on Instagram. On my website, farhadlectures.com, you will find additional resources to complement and supplement this course as well as your accounting and finance courses. I strongly suggest you check out my website. What is the basic idea of diversification? It's don't put all your eggs in one basket. I'm sure you heard that saying before, it means don't put all your investment toward one company or one entity or one type of risk. What should you do then? It means spread your eggs out. Don't put them in one basket, because if that basket falls, your eggs are gone. This is the basic idea. So let's think about what type of risks are you exposed to when you buy a stock. So let's assume you buy one single individual stock. To be more specific, let's assume you buy Tesla. Hopefully, you know what Tesla is. So when you buy Tesla, you are exposed to general economic condition risks such as business cycle. The business cycle goes up sometime. We're in good time, bad time, so on and so forth. You're exposed to that. So we're in good time. Tesla does well. We're in bad time. Tesla doesn't do well. Inflation. If we have inflation, the cost of money is higher. People might buy less cars. Interest rate. If interest rate is high, people are less likely to buy stuff because the cost of money is high. Exchange rates. If Tesla is selling their vehicles overseas and the US dollar is strong, then less people will buy it. So they have risk to exchange rate and other risks. Those risks are called general economic conditions. So Tesla as a company, there's nothing they can do about those risks. Those risks exist whether Tesla do well as a company or doesn't do well as a company. So they have to deal with those risks. They have to deal with those risks and have no control over those. Now Tesla also have their own firm specific risks. So I'm going to, I call the general economic risk A and I call the firm specific risk B, list B. So what are those firm specific risks? Well, for example, manufacturing cost target. One problem with Tesla is they're trying to cut down their cost because when they sell a car, they want to make sure they're making a profit and Tesla find a hard time cutting down their cost. So their cars are affordable to the general public. So they may not be able to reach that goal. Production delays. Why? Because of supply chain constraints. They're not getting the supplies that they want to. Also they might find hard time finding skilled workers to complete the work that they need to complete. They might have problem with management, style and philosophy. And those are all specific. Those are all specific issues that are related to Tesla. Also the government, they could change the regulation to the industry, which will affect Tesla as a firm. And you have to remember the competition from other car manufacturers like Ford, GE, Volkswagen, they're all trying to build electronic vehicles as well. Also we want to worry about Elon Musk tweets or Elon Musk smoking weed because that also affects the company itself. Also the perception about electric cars, the price of gasoline, access to charging facilities, etc. So those are firm specific factors that affect Tesla without noticeably affecting other firms. So when Elon Musk smoked the weed on the Joe Rogan show, well that affects Tesla specifically. When Elon Musk tweeted about the production they're going to produce 500,000 cars in 2019, well in reality that was not true. Elon Musk has to kind of take it back or explain his position and he always get into trouble with the security and exchange commission because he put all those tweets out. But those are firm specific. So how would you solve this? How do I solve this? I will not put all my money in Tesla. I will not put 100% of my money in Tesla. What should I do? Well to protect myself I will start with the diversification. So the idea of diversification is you don't put all your money in Tesla. So what can you do? Well one simple way, for example, this is simple, I put 50% in Tesla and I'll put 50% in Ford Motor Company or 50% in GE or 50% in Nissan and this is simple. This is not even diversification but at least I'm not putting all my money in one basket. Maybe I will buy Tesla and I will buy the other 50%. I don't get into involved in the car industry. I might buy Apple computers or I put 50% in Tesla and I'll put the remaining in Amazon. Now how about I'll put only 30% in Tesla, 30% in Amazon, 30% in Apple and I'll keep 10% in cash. That's also a good idea. So simply put, if you don't want to be exposed to firm specific because there's nothing you can do about this list. If you don't want to be exposed to firm specific, don't put all your money in one place, diversify. That's the idea of diversification is you are not exposed to what Elon Musk decides to do. You're exposed a little bit but hopefully when Elon Musk and Tesla don't do well, hopefully Apple or Amazon will do well. So it will make it up. So we have two types of risks. We have market risk which is list A, what we saw and we have diversified risk which is list B. Market risk, common source of risks that affect all firms. So those risks that I told you, the economic risk, the inflation risk, the business cycle, they affect all companies. Even with extensive diversification, you cannot eliminate those risks. So market risk is not diversifiable. There's nothing you can do even if you buy in different companies. If interest rate goes up, if interest rate goes up for all companies, it doesn't matter how many companies you are invested in. So this risk remains even after you diversify. It doesn't go away. This risk is attributed to market-wide risk resources. It's not firm specific. Another terms for this risk is called systematic risk or non-diversifiable risk. So systematic risk, non-diversifiable risk, market risk, they're all the same thing. Obviously the diversified risk is the risk that you can diversify. You can spread out. This is list B. The risk then can be eliminated by diversification. So don't expose yourself to Tesla alone. Expose yourself to several other companies. This risk is called unique risk because it's unique to the company. Firm specific risk or non-systematic risk versus the systematic risk. You always hear the systematic versus non-systematic risks. That's the best. That's the best term. Let me show you on a graph. What are we trying to say? This is the standard deviation. And remember, the standard deviation represent the risk. Here we have zero risk and the risk goes up to 30. Here's what happened. If you invest in one company, let's assume you invest in Tesla alone. Let's put one company here. Let's assume you invest. Obviously, if you invest in nothing, you're taken no risk. But let's assume you invest in one company. If you invest in one company alone, Tesla, you are at approximately 30% of standard deviation. Here's what happened. If you invest in two companies, your standard deviation should go down to 27. If you invest in three companies, it will go to 25. So notice, as you invest in more stocks, in more stocks, your risk goes down. Now, it doesn't go down forever. You cannot eliminate all the risk. And we're going to see why you cannot eliminate the old risk. But the idea is, as you invest in more companies, as the number of stocks goes up, your standard deviation should go down. And don't worry. We're going to compute this mathematically in the next session when we prepare a portfolio. So this is the idea. Another way to look at this is this. Again, we talked about when you invest in more company, your risk goes down. But also, there is a risk that's called the market risk. That's non-diversifiable. You cannot diversify. So this, you cannot get rid of. So you're going to have this risk. No one can get rid of. But rather than being here, by diversification, you can lower your risk down to here. So you have this much of firm risk rather than having this much of firm risk. So what you do is you reduce your exposure. So this is the market and unique risks that basically you are looking at. So there's nothing you can do about this part. This part, you can diversify. You can bring down to here. But you're always going to have some risk. And that's the nature of stocks. But the market risk, you cannot diversify. So make sure you know the difference between systematic and non-systematic risk and the general idea behind this. In the next session, we're going to start to build a portfolio. And we're going to allocate assets. Specifically, we're going to take a look at portfolio with tourist assets to illustrate the concept of diversification, whether it's 200 or 300. The concept is the same. So by starting with tourist asset, then we're going to add a third one later, third asset. Then you will start to get the idea how mathematically or from a statistical perspective, how you can reduce this standard deviation. And this is what we want. If you like this recording, please like it. Click on the like button, share it, put it in playlist. Also, don't forget to visit my website farhatlectures.com to complement and supplement this course with additional resources. Good luck, study hard, and stay safe.