Diversification as ERM

In the recent post, Rational Adaptability, four types of ERM programs are mentioned. One of those four types of ERM is Diversification.

The fourth type of ERM program focuses on Diversification.

Modern practitioners may not agree that a program of Diversification IS in any sense a risk management program.  But in fact it has been one of the most successful risk management programs.

Think about it.  Dollar Cost Averaging is fundamentally a Diversification based risk management program.  The practitioner is admitting that at any point in time, they do not know which risk is better or worse than another.  So they rebalance to eliminate the concentration that has crept into their portfolio.

A diversification risk strategy would also mean taking very different risks.  Firms that focus on a true Diversification strategy will be regularly moving into entirely new businesses.  They are not seeking the mathematical diversification of the Managers with their Risk Steering that tries to take advantage of similar risks that are not totally correlated.  Firms that follow the Diversification strategy want risks that are totally unrelated.  Soap and machine parts.  Their business choices may seem totally insane to the tidy Managers.

Diversification can be shown to provide two benefits for the firm that practices it.  First, they will seek to avoid having too much at risk in any one situation or company.  So avoiding concentration is their prime directive.  Second, there is an upside benefit as well.  Since they are involved in many different markets, they feel that they are likely to be in at least one and possibly two hot products or markets at any one time.  Unsuccessful practitioners of this strategy will find that they have found a way to buy into different risks that are all duds at the same time.

The practitioners of this strategy will also tend to adopt the same sort of approach to the day to day work of their risk management program.  That would be the “high attention, low delegation” approach.  The conglomerates that operate in this manner will have frequent meetings between the managers and the people at the top of the conglomerate, possibly even with the top person.  Warren Buffett (Berkshire Hathaway) and Jack Welsh (GE) are two examples of this high touch style as is Hank Greenberg (AIG).

Seems pretty simple.  Mix it up and pay attention.

A few firms have managed to combine the high tech economic capital modeling approach with a Diversification ERM system.  In those firms, they have strict concentration limits requiring that at most a small percentage of their economic capital ever be from any one risk.  One such firm will never take on any large amount of any one risk unless they are able to grow all of their other risks.

This post is a part of the Plural Rationalities and ERM project.

Explore posts in the same categories: Cultural Theory of Risk, Diversification, Enterprise Risk Management, ERM


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2 Comments on “Diversification as ERM”

  1. […] Pragmatist will seek to diversify.  Not only will they want to diversify their risks as Ms. Saunders suggests as her very first […]

  2. […] this would allow a firm to actually do Risk Steering.  And to more quantitatively assess their Diversification.  So this quality is needed to support two of the four key ERM Strategies and is also needed to  […]

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