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Since trading is required the largest investor may

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Unformatted text preview: s Diversifying across domestic stocks can mitigate by Aswath Damodaran Diversifying across countries Diversifying globally Actions/Risk that affect all investments Cannot affect Diversifying across asset classes 76 Why diversificaJon reduces/eliminates firm specific risk 77 ¨༊  ¨༊  Firm- specific risk can be reduced, if not eliminated, by increasing the number of investments in your porlolio (i.e., by being diversified). Market- wide risk cannot. This can be jusJfied on either economic or staJsJcal grounds. On economic grounds, diversifying and holding a larger porlolio eliminates firm- specific risk for two reasons- a.  b.  Each investment is a much smaller percentage of the porlolio, muJng the effect (posiJve or negaJve) on the overall porlolio. Firm- specific acJons can be either posiJve or negaJve. In a large porlolio, it is argued, these effects will average out to zero. (For every firm, where something bad happens, there will be some other firm, where something good happens.) Aswath Damodaran 77 The Role of the Marginal Investor 78 ¨༊  ¨༊  ¨༊  ¨༊  The marginal investor in a firm is the investor who is most likely to be the buyer or seller on the next trade and to influence the stock price. Generally speaking, the marginal investor in a stock has to own a lot of stock and also trade that stock on a regular basis. Since trading is required, the largest investor may not be the marginal investor, especially if he or she is a founder/manager of the firm (Larry Ellison at Oracle, Mark Zuckerberg at Facebook) In all risk and return models in finance, we assume that the marginal investor is well diversified. Aswath Damodaran 78 IdenJfying the Marginal Investor in your firm… 79 Percent of Stock held by Percent of Stock held by Marginal Investor Institutions Insiders H igh L ow Institutional Investora H igh H igh Institutional Investor,...
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