Sunday, 22 November 2009

Responding to risks: Diversifying risks

Diversifying is about 'spreading risk around' - reducing your potential exposure by not having all eggs in one basket.  It reduces potential negative impact, but this normally results in extra costs.

Diversification can be a good tactic where there are problems in keeping the risk 'in one place', perhaps because there is a big potential downside.  For example, printers are dependent on paper suppliers to keep their operations running.  By setting up many suppliers for this commodity, they make it more likely that they will be able to get cover from another supplier if one can't delviver, thus reducing the potential downside risk of running out of paper.  (They also reap a number of side benefits, such as the opportunity to benchmark the prices of different suppliers, gain information about suppliers, find out about different ways of handling their orders and transactions and so on.)

However, there's always a downside.  There will be more administrative work in handling a large number of suppliers, and more management decisions to be made about which one will be used in each case; is price the only factor, or is the commercial relationship important too?

Diversification is also a good strategy for managing financial risk.  Investment vehicles that give investors the chance to invest in a range of companies offer those with little stock market knowledge a way to invest with reduced risk of exposure to market volatility in comparison with direct investment in a singloe company.

The key to diversification is keeping the different risks as separate from each other as possible, or reducing interdependencies between them.  No amount of diversification will protect against a worldwide recession, but investing in different economies around the world will offset the risk of a downturn in any particular one of them.

In a project contex, diversification can improve the chances of success.  Suppose a project has a 0.8 (80%) probability of failure.  It follows that the probability of success is 0.2 920%) - not particularly good.  Perhaps it is a speculative research and development project aimed at creating a new product.

But what if we ran two such projects?  The probability of both failing is 0.8 x 0.8 = 0.64 (64%) .  And if we ran three, the probability of ALL THREE  failing would be 0.8 x 0.8 x0.8 = 0.512 (51.2%), making the probability of having at LEAST ONE success nearly 50% (0.488 or 48.8%).  As we add more and more projects, the chances of success in at least one case steadily increases.  With 20 projects, our chances of having one success are 0.99 (99%) - we would be almost certain to succeed in one of the 20 projects. 

Diversifying risk through multiple projects:

Probabiltiy of total failure -----  Probability of single success                          
Run a single project
80% (0.8) ---- 20% (0.2)
Run two projects
64% (0.8x0.8) ---- 36% (0.36)
Run three projects
51.2% (0.8x0.8x0.8) ---- 48.8% (0.488)
Run 20 projects
1% (0.8^20) ---- 99% (0.99)

This illustrates how diversification can improve the chances of success, although at a price.  Running 20 projects will be much more expensive than running one.  But it may be that 20 modest projects, each researching a different potential product, are a better way forward than a single 'all or nothing' project puttting lots of resource into a single product.

An important point to remember is that the 'winners' must pay for the 'losers' if you choose to go for diversification.  The business must be able to afford to take all these risks, with all their respective potential downsides, and be confident that there is no risk of bankruptcy as a result.

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