Securities Market and Investment Diversification, Essay Example

Companies, primarily financial institutions, invest and trade in securities for various reasons. For whatever reasons or purpose of involvement in securities investments and/or trading, there are key benefits that a company may accrue, short-term and long-term due to activity in the securities market.

The main reason and benefit of a company investing and trading in securities is the making of profit off the fluctuations and differences in prices of these securities in the short-term. Take an example of AIG buying equities (stocks) of other companies at a lower price, selling hem when the prices go up, thus making profits on the fluctuation.

The other reason for companies investing and trading securities is to own stakes in other companies that they deem profitable. When AIG recognizes that McDonald’s is making profits, maybe abnormal profits, they will purchase a percentage stake in McDonald’s in the form of McDonald’s shares and own a portion of McDonald’s profitability.

The domestic securities markets enable a company to own portions of a given industry by purchasing stocks of the given companies within the industry. This allows for them to diversify its trading and investments portfolio locally, building bargaining power within a given industry. For example, AIG may decide to buy Chrysler automobile stocks to diversify their trading and investments. This allows them to influence the local automobile industry by buying as many shares in Dodge as they possibly can.

Investment diversification, through purchase of investments with varying risks and rewards, is a risk management strategy. By purchasing stocks that have different characteristics, depending on the investment timeline desired for the given investments, a company reduces, or rather, spreads its risks. For example AIG can decide to create an investment portfolio involving 10 different stocks across 5 different sectors of the economy. For example AIG can buy Chrysler and Ford stocks in the automobile industry, Coca-Cola and Pepsi stocks in the beverage industry, Tuborg and Heineken in the alcoholic beverage industry, McDonald’s in the fast food chain store industry, etc. Through purchase of these different stocks, AIG can shield themselves from negative effects of market movements within a given industry.

A financial analyst would be able to determine whether the reward of trading a particular stock or investment by using various financial tools available to them. One such tool is the risk-reward ratio which helps the financial analyst determine the risks of a particular investment, the reward of the same investment and when pitted against each other, which side is stronger. This ratio is obtained by first determining the amount of money required for the investment. This is the amount that is at risk should the investment not bear fruit. The gain is determined by the amount expected to be generated from the investment. Both the risk and gain are multiplied by the number of lots expected to be traded.

Another tool is the determination of the ROI (return-on-investment). Tis is determining the amount of money expected to be generated from the investment. When this margin is higher than a desired percentage, then the investment is worthwhile. AIG may adopt a 55% or 0.55 ROI margin, this means that investments are considered viable and worthwhile if and only if their ROI is over 0.55. Such financial tools also depend on the investor’s attitude towards risks associated to the given investments and their given style of trading, i.e. short-run investments tend to attract higher profit margins, but higher risks while long-term investments tend to attract little risks and little profit margins. However, this may not always be true.