Concentration, defined broadly, is the source of all risk.
In an unconcentrated pool of activities, all with potential for positive and negative outcomes, provides the Big D – Diversification.
So it seems simple to avoid C – just do D.
But we have so many ways to concentrate. And concentration is particularly tempting.
- When things are going well, it makes sense to do more of whatever it is that is working best. That increases concentration.
- Once we learn how to do something right, it makes sense to do more. That increases concentration.
- One supplier is almost always the cheapest, fastest and best quality. So we give them more business. That increases concentration.
- That one product has better margins than the rest and it sells better too. So we plan to increase our capacity to make that product. That increases concentration.
- Our best distributor runs rings around the rest. We are working on giving her a larger territory. That increases concentration.
The alternative, the diversifying alternative just doesn’t sound so smart.
- Hold back when things are going well.
- Do more of the things that you haven’t quite mastered.
- Buy from the second and third best suppliers.
- Keep up capacity for the lower margin lower selling products.
- Restrict your best distributor from selling too much.
Remember Blockbuster? There were Blockbuster stores everywhere fifteen years ago. They did that one thing, rent physical videos through physical stores and did it so well that they drove out most of their competition. But they were totally Concentrated. When they were faced with a new competitor, Netflix, the CEO proposed changes to their business practices, including diversifying into online rentals. Their board decided against going into a new lower margin product and fired the CEO. Five years later, Blockbuster was toast.
Concentration risk is often strategic.
In the financial crisis, we found a new sort of concentration risk. It was a network risk. The banks were all highly concentrated in the financial sector – in exposure to other banks. This network risk is now often called systemic risk. But this risk is necessary because of the strategic choices of business models of the banks. They all choose to do business in such a way to take up each other’s slack on a daily basis. They all think that is much more efficient than operating with an irregular amount of slack resources. In times running up to the financial crisis, the interdependency changed from just taking up each other’s overnight slack to some banks using that overnight facility from other banks to fund major fraction of their business activity. (And woe is all that much of that business activity was fundamentally a loser. But that lack of underwriting by the banks of each other is a different story.)
Why is concentration risk so deadly? The answer to that is pretty simple arithmetic. If your conglomerate amounts to four similar sized separate divisions that do not interact so much, it is quite possible that if one of those businesses fails, that the conglomerate will be able to continue operating – wounded but fully able to operate the other three divisions. But if your cousin’s venture has just one highly profitable, highly successful business, then his venture will either live or die with that one business.
In insurance, we see this concentration risk all of the time. If you are an insurer that only writes business throughout the Pacific islands in the 1700’s, but you find that your best salesperson is on Easter Island and your highest margin product is business interruption insurance for the businesses that do the carving of the massive Moai statues. So you do more and more business with your best salesperson selling your best product, until you are essentially a one product, one location insurer. And then the last tree is used (or rats eat the roots). All of your customers make claims at once. You thought that you were diversified because you had 300 separate customers. But those 300 customers all acted like just one when the trees were gone.
So diversification is not just about counting. It is about understanding the differences or similarities of your risks. And failure to understand those drivers will often lead to dangerous concentration. Just ask those banks or that Easter Island insurer.