![]() There are plenty of different diversification strategies to choose from, but their common denominator is buying investments in a range of different asset classes. While not each and every investment in a well-diversified portfolio will be negatively correlated, the goal of diversification is to buy assets that do not move in lockstep with one another. Even at the rare moments when stock prices and bond yields move in the same direction (both gaining or both losing), stocks typically have much greater volatility-which is to say they gain or lose much more than bonds. Professionals would say stocks and bonds are negatively correlated. When stock prices are rising, for example, bond yields are generally falling. One key to diversification is owning investments that perform differently in similar markets. This fact underscores the challenges of trying to pick just a few winning investments. Over time, a diversified portfolio generally outperforms the majority of more focused one. At any given time, investors who concentrate capital in a limited number of investments may outperform a diversified investor. Since the future is highly uncertain and markets are always changing, we diversify our investments among different companies and assets that are not exposed to the same risks.ĭiversification is not designed to maximize returns. If we had perfect knowledge of the future, everyone could simply pick one investment that would perform perfectly for as long as needed. Investors also often demand equity stakes in order to capture future profitability and growth that debt instruments do not provide.You need diversification to minimize investment risk. However, as more debt is accumulated, the credit risk associated with that debt also increases and so equity must be added to the mix. ![]() Firms will decide the appropriate mix of debt and equity financing by optimizing the WACC of each type of capital while taking into account the risk of default or bankruptcy on one side and the amount of ownership owners are willing to give up on the other.īecause interest on the debt is typically tax deductible, and because the interest rates associated with debt is typically cheaper than the rate of return expected for equity, debt is usually preferred. By taking a weighted average in this way, one can determine how much interest a company owes for each dollar it finances. The weighted average cost of capital (WACC) is the average of the costs of all types of financing, each of which is weighted by its proportionate use in a given situation. Both debt and equity have their advantages and disadvantages. ![]() Equity does not need to be paid back, but it relinquishes ownership stakes to the shareholder. Debt is a loan that must be paid back often with interest, but it is typically cheaper than raising capital because of tax deduction considerations. There are two main types of financing available for companies: debt financing and equity financing. The weighted average cost of capital (WACC) gives a clear picture of a firm's total cost of financing.However, large debt burdens can lead to default and credit risk. Debt financing tends to be cheaper and comes with tax breaks.Equity financing places no additional financial burden on the company, though the downside is quite large. The main advantage of equity financing is that there is no obligation to repay the money acquired through it.There are two types of financing: equity financing and debt financing.Financing is the process of funding business activities, making purchases, or investments.
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