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Manage Risk Through Diversification
August 2005
STANFORD GRADUATE SCHOOL OF BUSINESS
Phillip Leslie, Assistant Professor of Strategic Management is frequently asked about diversifying to manage risk and return.
QUESTION: Investors are encouraged to diversity their portfolios to achieve the risk-return tradeoff that is best for them individually. At the same time company managers often talk about the need to diversify the businesses within their own companies in order to lower risk. Are these conflicting ideals?
LESLIE'S REPLY: On the face of it, yes. The desire of firms to diversify for the purpose of risk reduction is inconsistent with shareholder value maximization. The conventional view in economics is that managers should maximize expected profit without heed to the risks involved, and investors choose diversified portfolios to mitigate risk. That's not to say there aren't good reasons for a company to be diversified. For example, there may be synergies between firms in different markets that can only be exploited if there is common ownership. However, diversification for the purpose of risk management by the company managers is not a valid justification. Moreover, economists tend to be skeptical of such reasoning given by firms, suspecting it to be a veil for empire building. Note that this does not apply to private companies. If you own your own business with a significant fraction of your wealth invested in it, diversifying your own personal portfolio means diversifying the company.
Having said that, you may be wondering: If managers can lower the volatility of the firm's profits, won't this reduce the cost of capital, which is good for profitability and shareholders? Maybe, but there are usually much cheaper ways, such as using financial instruments, to reduce volatility than by buying companies or greenfield entry into new markets. Indeed, several companies, like Cemex, are well known for their sophisticated use of financial tools to lower their cost of capital. Before financial markets were as well developed as they are today, it probably made more sense for firms to diversify for risk management purposes. But these days, I would be skeptical of such reasoning.