Page 209 - SBL Integrated Workbook STUDENT 2018

Managing, monitoring and mitigating risk

3.3 Diversifying/spreading risk

 Risk can be reduced by diversifying into operations in different areas, such as
into Industry X and Industry Y, or into Country P and Country Q.

 Poor performance in one area will be offset by good performance in another
area, so diversification will reduce total risk.

 Diversification is based on the idea of ‘spreading the risk’; the total risk should
be reduced as the portfolio of diversified businesses gets larger.

 From your F9 studies you will remember that diversification works best where
returns from different businesses are negatively correlated (i.e. a change in the
business environment causes returns to move in opposite directions). It will,
however, still work to a degree as long as the correlation is less than +1.0.

 Example of poor diversification – swimming costumes and ice cream – both
reliant on sunny weather for sales.

 Spreading risk relates to portfolio management where an investor, or company,
spreads product and market risks.

Risk can be spread by expanding the portfolio of companies held. The portfolio can
be expanded by integration – linking with other companies in the supply chain, or
diversification into other areas.

This is development beyond the present product and market, but still within the broad
confines of the ‘industry’.

 Backward integration refers to development concerned with the inputs into the
organisation, e.g. raw materials, machinery and labour.

 Forward integration refers to development into activities that are concerned with
the organisation’s outputs e.g. distribution, transport, servicing and repairs.

 Horizontal integration refers to development into activities that compete with, or
directly complement, an organisation’s present activities e.g. a travel agent
selling other related products such as travel insurance and currency exchange
services.

Illustrations and further practice

Now try TYU questions 2 and 3.

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